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THE  FUNDAMENTALS 
OF  ACCOUNTING 


BY 
WILLIAM  MORSE  COLE,  A.M. 

Professor  of  Accounting  in  Harvard  University 
Author  of  "Accounts:  Their  Construction  and  Interpretation  " 


WITH  THE  COLLABORATION  OF 

ANNE  ELIZABETH  GEDDES,  A.B. 


HOUGHTON  MIFFLIN  COMPANY 

BOSTON  •  NEW  YORK  •  CHICAGO  •  DALLAS  •  SAN  FRANCISCO 


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ALL  RIGHTS  RXSSRVSD 


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CAMBKIDOB  .  MASSACHUSBTTS 
riUNTED  IN  THB  U  .  S  .  A 


PREFACE 

The  most  striking  development  in  the  educational  field  of  late  is 
the  rush  of  students  to  the  commercial  departments  of  our  sec- 
ondary schools  and  our  colleges.  Whatever  else  is  or  is  not 
taught  in  such  departments,  accounting  (in  the  colleges)  or  book- 
keeping (in  the  secondary  schools)  is  taught.  All  over  the  coim- 
try,  moreover,  correspondence  schools  and  evening  schools  are 
teaching  accounting.  Thousands  of  students  of  accounting  are 
graduated  from  one  or  another  kind  of  school  every  year,  and  yet 
professional  accoimtants  are  constantly  calling  for  good  men  and 
cannot  get  them.  This  is  not  because  the  demand  is  tremendous, 
for  the  number  of  practicing  accountants  in  the  country  is  not 
large,  but  because  the  supply  is  small.  Comparatively  few  who 
study  accoimting  prove  competent  for  responsible  positions. 

Accounting  requires  a  certain  type  of  native  mental  capacity, 
as  well  as  a  certain  amount  of  training.  That  type  of  native  ca- 
pacity happens  to  be  rare.  Two  essentials  for  accounting,  as  dis- 
tinguished from  bookkeeping,  are  a  highly  developed  analytical 
faculty  and  a  good  imagination.  The  first  is  rare  at  best,  and  it 
does  not  commonly  go  along  with  the  second.  It  is  futile  to  try 
to  produce  accountants  from  material  that  is  lacking  in  either 
faculty.  Any  teacher  of  the  subject  should  understand  at  the  start 
th;  of  the  many  who  fancy  themselves  called  few  will  ever  be 
(^jsen.  Yet  though  few  can  ever  be  accountants,  every  person 
charged  with  executive  responsibility  should  know  the  fundamentals 
of  accounting,  for  he  cannot  understand  the  reports  of  his  own  busi- 
ness (if  he  has  a  good  accountant)  unless  he  knows  what  the  account- 
ant is  talking  about,  and  he  cannot  direct  even  elementary  ac- 
counting (if  he  has  not  a  good  accountant)  imless  he  knows  what 
constitutes  good  accounting.  Every  student  of  public  affairs, 
moreover,  should  be  able  to  interpret  financial  reports,  both  public 
and  private,  and  know  what  business  facts  lie  behind  them.  The 
study  of  accounting,  therefore,  is  not  futile  even  for  those  who 
cannot  be  accountants. 

A  result  of  the  rush  of  college  students  to  commercial  studies, 

748149 


IV  PREFACE 

and  away  from  the  humanities,  is  alarm  on  the  part  of  college  au- 
thorities regarding  the  mental  training  that  under  the  new  regime 
their  students  will  get.  However  regrettable  may  be  the  neglect 
of  the  humanities,  because  of  the  limitation  of  the  field  to  which 
the  new  studies  largely  confine  themselves,  there  need  be  no  loss  of 
mental  training.  As  philosophy  and  mathematics  are  disciplinary 
studies,  and  in  the  old  program  are  desired  not  only  for  their  con- 
tent, but  for  their  disciplinary  value,  in  the  new  program  account- 
ing may,  so  far  as  discipline  is  concerned,  take  their  place.  It  is 
a  compound  of  philosophy  and  mathematics  —  that  is,  the  only 
method  of  teaching  it  that  makes  either  successful  accountants  or 
successful  interpreters  of  accounts  is  the  method  of  teaching  philos- 
ophy and  mathematics.  Accounting  must  proceed  by  reasoning, 
not  by  rule :  it  is  not  a  body  of  arbitrary  facts,  true  merely  because 
they  are  true,  and  therefore  to  be  memorized:  it  is  a  body  of  plain 
common  sense,  developed  out  of  hard  thinking  about  facts  that 
have  been,  and  imagination  to  see  what  future  need  will  arise  for 
record  to-day  of  facts  that  are.  It  calls  for  mental  activity  of  the 
highest  type:  it  is  not  virginibus  ptierisque. 

Yet  its  value  both  as  a  disciplinary  study  and  as  vocational  train- 
ing depends  wholly  upon  the  method  of  instruction.  No  one  will 
ever  use  accounts  successfully  who  is  not  able  to  think  in  abstract 
terms  about  them,  for  like  mathematical  terms  and  philosophical 
concepts  they  are  to  great  extent  abstractions  —  except  the  simple 
bookkeeping  items  of  cash,  accounts  receivable,  etc.  One  rea- 
son, moreover,  why,  with  thousands  of  students  graduating  in  ac- 
counting annually,  professional  accountants  are  not  able  to  get 
good  men  is  that  so  much  of  the  work  of  the  students  has  been  of 
the  memorizing  rather  than  the  reasoning  variety.  The  students 
have  taken  accounting  as  if  it  were  a  body  of  scientific  facts  to  be 
memorized  rather  than  a  philosophy  of  accounting  conduct. 

The  method  of  this  book  is  the  philosophical.  It  starts  with  the 
simplest  obvious  fact  needing  record,  property  and  ownership, 
and  from  this  develops  the  need  of  particular  accounts.  Not  for 
several  chapters  is  any  need  found  for  the  always  confusing  nom- 
inal accounts,  and  then  they  develop  naturally  after  the  statisti- 
cal need  for  them  has  arisen.  The  technique  of  bookkeeping  does 
not  appear  imtil  the  ninth  chapter,  and  then  it  results  from  a 


PREFACE  V 

need  of  labor-saving  devices.  This  technique  is  dwelt  upon  only 
enough  to  show  the  feasibility  of  most  of  the  information  that  the 
accountant  desires.  Indeed,  though  bookkeeping  is  the  tool  of 
accounting,  it  is  a  tool  so  simple  in  principle  that  to  ask  any  one 
who  does  not  intend  to  be  either  a  bookkeeper  or  a  professional 
accountant  to  spend  many  months  in  studying  it  is  almost  an 
educational  crime.  Indeed,  the  whole  method  of  procedure  is 
based  on  the  fact  that  nothing  is  of  interest  until  some  need  of  it, 
or  curiosity  about  it,  is  felt. 

Though  the  book  deals  with  fundamentals,  it  is  not  superficial; 
for  fundamentals  are  always  the  contrary  of  superficialities.  As  far 
as  it  goes,  it  is  complete.  It  does  not  avoid  a  matter  because  it 
chances  to  be  abstract  or  difficult:  if  it  did,  it  would  have  neither 
discipHnary  nor  practical  value.  It  attempts  to  give  all  the  funda- 
mental considerations  of  accounting.  What  more  there  is  to  ac- 
counting is  the  application  of  these  principles  to  situations  in 
which  careful  analysis,  based  on  detailed  knowledge  of  the  par- 
ticular business,  has  found  a  way  of  application,  sometimes  through 
a  maze  of  complexity  of  business  relations. 

On  the  part  of  the  senior  author,  the  selection  of  material  and 
the  method  of  exposition  follow  twenty  years  of  University  ex- 
perience in  teaching  accounting.  The  junior  author,  on  the  other 
hand,  who  has  but  recently  been  a  student  of  accounting,  under 
methods  of  instruction  similar  to  those  incorporated  here,  and  of 
late  has  been  assisting  the  senior  both  in  some  of  his  teaching 
and  in  the  practice  of  accounting,  brings  to  the  collaboration  the 
combined  point  of  view  of  the  student,  the  young  instructor,  and 
the  practitioner. 

To  give  concreteness  to  the  principles  worked  out  here,  appended 
to  every  chapter  are  questions  and  problems  which  test  the  read- 
er's ability  to  apply  his  principles.  These  are  intended  not  for  rep- 
etitious drill,  but  as  illustrations  of  how  the  principles  apply  to 
concrete  facts.  If  any  one  wishes  drill,  he  can  easily  make  addi- 
tional problems  for  himself.    Those  given  afford  large  variety. 

W.  M.  C. 
A.  E.  G. 
Cambridge,  Massachusetts 
November  22,  1Q20 


CONTENTS 

I.  Introduction  i 

Accountant  like  an  editor,  i  —  what  accountant  edits,  2  —  kinds  of  ac- 
counting, 3  —  relation  between  accounting  and  bookkeeping,  4^ —  depend- 
ence on  bookkeeping,  5  —  accounting  for  non-accountants,  6. 

II.  Double  Entry  and  the  Balance  Sheet  7 

Basis  of  double  entry,  7  —  balance  sheet,  8  —  assets,  8  —  ownership- 
claims,  8  —  temporary  validity  of  balance  sheet,  9  —  balance  sheet  al- 
ways in  balance,  10  —  kinds  of  changes  in  assets,  10  —  double  aspect,  11  — 
changes  in  ownership-claims,  11  —  balance  in  all  transactions,  12  —  as- 
sets determining  ownership-claims,  12  —  balance-sheet  illustrations,  13  — 
all  types  of  changes  in  double  aspect,  16  —  business  as  entity,  18  —  ques- 
tions and  problems,  18. 

III.  The  Fundamental  Principle  of  Debit  and  Credit  20 

Definition  of  account,  20  —  need  for  bookkeeping  device,  20  —  what 
changes  need  record,  21  —  explanation  of  changes  in  assets,  22 — explanation 
of  changes  in  ownership-claims,  22  —  similarity  of  different  types  of  en- 
try, 23  —  debit  and  credit  differentiated,  23  —  meaning  of  credit,  24  — 
general  scheme  of  debit  and  credit,  24  —  forms  of  ledger  accounts,  25  — 
changes  affecting  assets,  26  —  changes  affecting  ownership-claims,  26  — 
sxmmiary,  26  —  illustrations,  27  —  questions  and  problems,  31. 

IV.  The  Interpretation  of  Debit  and  Credit  33 

Nature  of  debit  and  credit,  33  —  examination  of  typical  debits,  34  — 
temporary  uncertainty  possible,  39  —  summary  of  debits,  40  —  examina- 
tion of  credits,  41  —  general  sunmiary,  42  —  questions  and  problems,  43. 

V.  The  Income  Sheet  44 

Records  necessary  between  balance  sheets,  44  —  knowledge  of  income  not 
enough,  44  —  separate  accounts  to  show  cause  and  effect,  45  —  complete 
statement  of  profits  and  losses,  46  —  net  effect  of  income  sheet  reflected  in 
balance  sheet,  47  —  questions  and  problems,  48. 

VI.  The  Operating  Statement  —  Under   Cost-Accounting 

Methods  50 

Knowledge  of  specific  costs  and  specific  sources  of  gain  given  by  subdivi- 
sion of  accounts,  50  —  typical  cost  accounts,  51  —  assets  changing  form, 
52  —  current  changes  recorded,  53  —  current  changes  not  recorded,  53  — 
goods-in-process  account,  54  —  finished  goods  accoimt,  55  —  sold  goods 
account,  55  —  summary,  55  —  precautions,  56  —  illustration,  57  —  trans- 
fer of  elements  to  goods-in-process,  58  —  relation  between  principal  and 
subdivisional  accoimts,  60  —  profit  and  loss,  60  —  the  operating  state- 
ment, 63  —  comparison  of  operating  statement  with  income  sheet,  65  — 
when  entries  are  made,  66  —  questions  and  problems,  67. 


viii  CONTENTS 

VII.  The  Operating   Statement  —  Under   the   Inventory 

Method  69 

Inventory  method  described,  69  —  consolidation  of  costs,  70  —  profit  and 
loss,  74  —  the  operating  statement,  74  —  comparison  of  methods,  74  — 
converted  assets  account,  75  —  profit  and  loss  account,  77  —  distinction 
between  nominal  and  real  accounts,  78  —  mixed  accounts,  79  —  use  of 
nominal  accounts,  80  —  questions  and  problems,  82. 

VIII.  The  Content  of  Common  Accounts  84 

Fixing  the  content  of  accounts,  84  —  groups  of  accounts  reviewed,  84  — 
other  classifications,  86  —  flexibility  of  ledger  titles,  87. 

Asset  Accounts.  The  impermanence  of  assets,  88  —  cash,  89  —  mer- 
chandise, 89  —  shipments,  91  —  notes  receivable,  91  —  accounts  receiva- 
ble, 95  —  goods-in-process,  96  —  raw  material,  96  —  supplies,  97  —  furni- 
ture and  fixtures,  98  —  equipment,  99  —  machinery,  99  —  power  plant, 
99  —  real  estate,  99  —  bonds  owned,  100  —  stocks  owned,  loi  —  funds, 
loi  —  interest  as  an  asset,  102  —  rent  as  an  asset,  104  —  other  accrued 
and  prepaid  assets,  104  —  rights,  105  —  suspense  accounts,  106  —  con- 
tingent assets,  106. 

Contra  Accounts.  Allowance  for  shrinkage,  107  —  allowance  for  dis- 
counts, no  —  provision  for  hazard,  in. 

Ownership-Claim  Accounts.  Proprietors'  investment,  112  —  propri- 
etors' drawings,  112  —  proprietors'  loans,  113  —  capital  stock  and  bonds 
issued,  113  —  notes  payable,  113  —  accounts  payable,  114  —  other  paya- 
bles, 115  —  accrued  liabilities,  115  —  liability  on  prepayments,  115  — 
undivided  profits  and  surpluses,  116  —  contingent  liabilities,  116. 

Nominal  Accounts.  Nominal  accounts  tied  to  real  accounts,  117  — 
nominal  accounts  with  double  aspect,  117  —  sales,  118  —  purchases,  119 
—  freight  and  cartage,  119  —  discount  given  and  taken,  119  —  discount 
forfeited,  122  —  rental  charges  and  rental  earned,  123  —  loss  from  bad 
debts,  124  —  depreciation  and  maintenance,  126  —  other  nominal  ac- 
counts, 127  —  interest  accounts  as  typical,  128. 

Clearing  Accounts.  Nature  of  clearing  accounts,  130  —  clearing  ac- 
count for  merchandise,  131  —  cash  discounts  as  profit  or  loss,  132  — 
clearing  account  for  trading,  133  —  asset  clearing  accounts,  134  —  profit 
clearing  accounts,  134  —  distributive  clearing  accounts,  134  —  clearing 
accounts  real  or  nominal,  135. 

Questions  and  problems,  136. 

DC.  The  Fundamental  Principles  of  Bookkeeping  Method    142 

Original  entries,  142  —  ledger  form,  143  —  ledger  balances,  144  —  form 
of  original  entries,  146  —  journalization,  147  —  the  journal,  147  —  com- 
plete record,  148  —  the  entry,  149  —  illustrations,  149  —  correcting  er- 
rors, 152  —  correction  entries,  153  —  loose-leaf  books,  154  —  questions 
and  problems,  154. 

X.  The  Trial  Balance  157 

Purpose,  157  —  necessity,  157  —  limitations,  158  — totals  or  balances, 
158  —  places  of  error,  159  —  finding  errors,  162  —  questions  and  prob- 
lems, 163. 


CONTENTS  ix 

XI.  The  Principles  of  Labor-Saving  Devices  in  Books  of 

Original  Entry  165 

The  special  column,  165  —  wide  applicability,  166  —  extension  of  princi- 
ple, 167  —  cash  book,  168  —  purchase  book,  170  —  sales  book,  171  —  di- 
vision of  entries,  172  —  division  of  transactions,  173  —  abuse  of  labor  sav- 
ing, 174  —  loose-leaf  books,  175  —  questions  and  problems,  175. 

Xn.  The  Principles  of  Labor-Saving  Devices  in  Ledgers      178 

Subordinate  ledgers,  178  —  controlling  accounts,  180  —  subordinate- 
ledger  abstracts,  180  —  extension  of  principle,  182  —  subdivision  of  con- 
trolling accounts,  182  —  questions  and  problems,  183. 

XIII.  Some  Highly  Developed  Labor-Saving  Devices  185 

Cash  discounts,  185  —  purchase  book,  stock  book,  and  purchase  ledger 
combined,  191  —  tabular  ledger,  as  book  of  original  entry,  193  —  voucher- 
payable  system,  a  substitute  for  a  ledger,  195  —  private-ledger  system, 
199  —  questions  and  problems,  206. 

XIV.  The  Technique  of  Closing  the  Books  209 

Purpose  of  closing  the  books,  209  —  varying  task  of  closing,  209  —  what  is 
to  be  closed,  212  —  effect  to  be  produced,  212  —  fundamental  methods  of 
closing,  213  —  making  operating  accounts  real,  213  —  making  operating 
accounts  nominal,  215  —  direct  ledger  closing,  217  —  comparison  of 
methods  of  closing,  219  —  forms  preliminary  to  closing,  223  —  six-column 
statement,  223  —  proof  of  statement,  226  —  illustration,  227  —  other 
similar  statements,  228  —  allowances  for  future  payments,  230  —  ques- 
tions and  problems,  231. 

XV.  Auxiliary  Records  236 

Use  of  petty  cash,  236  —  impressed  system  of  petty  cash,  236  —  note 
book,  or  bill  book,  238  —  accounts-receivable  book,  and  accounts-payable 
book,  239  —  ticklers,  241  —  statistics  of  purchases,  242  —  statistics  of 
expenses,  243  —  statistics  of  production,  244  —  other  statistics,  244  — 
methods  of  gathering  statistics,  245  —  incorporating  statistics  in  ledger 
accounts,  245  —  illustrated  in  municipal  administration,  246  —  general 
comment  on  statistics,  247  —  questions  and  problems,  247. 

XVI.  Some  Pecullarities  of  Corporation  Accounts  249 

Essential  nature  of  corporations,  249  —  capital-stock  accoimt  in  practice, 
250  —  distinction  between  issue  and  sale,  251  — proper  method  of  han- 
dling capital  stock,  252  —  unsubscribed  capital  stock  authorized,  252  — 
subscriptions,  253  —  stock  issued  at  above  par,  255  —  stock  issued  at  be- 
low par,  257  —  donations  of  stock,  258  —  forfeited  subscriptions,  261  — 
converting  private  into  corporate  business,  262  —  confusion  between  prof- 
its and  assets,  263  —  distribution  of  profits,  263  —  undivided  profits,  264 

—  surplus,  266  —  special  surpluses,  266  —  deficit,  267  —  effect  of  profits  on 
values,  268  —  increase  of  capital  from  profits,  269  —  stock  dividends,  271 

—  stocks  without  par  value,  272  —  bonds,  273  —  questions  and  prob- 
lems, 273. 


X  CONTENTS 

XVII.  Where  DO  Profits  BEGIN  ?  276 

What  are  costs,  276  —  vagueness  of  "cost,"  276  —  independence  of  cost 
and  selling  price,  277  —  independence  of  cost  and  replacement,  278  —  cost 
as  outlay,  280  —  finding  the  costs,  281  —  division  of  costs  between  periods, 
282  —  cost  and  inventories,  284  —  profit  on  contracts,  287  —  capital 
losses  as  costs,  288  —  statement  of  surplus,  289  —  capital  gains,  290  — 
special  gains,  290  —  income  taxes,  291  —  summiary,  291  —  questions  and 
problems,  291. 

XVIII.  Depreciation  and  Maintenance  295 

Summary  of  previous  discussion,  295  —  depreciation  without  mainte- 
nance, 295  —  maintenance  without  depreciation,  296  —  maintenance  with 
depreciation,  297  —  depredation  of  new  property,  298  —  the  debits  and 
credits,  299  —  objection  to  frequent  record  of  depredation,  300  —  re- 
pairs, replacements,  and  betterments,  301  —  methods  of  estimating  de- 
preciation, 301  —  simple  bases  of  depreciation,  302  —  the  straight-line 
method,  302  —  the  sinking-fund  method,  303  —  the  redudng-balance 
method,  303  —  the  redudng-fraction  method,  304  —  depreciation 
charted,  305  —  application  of  blanket  rates,  306  —  appraisal  method,  306 

—  providing  for  replacement,  306  —  bookkeeping  record  of  conversion 
operations,  308  —  special  provision  for  replacement,  309  —  when  no  re- 
placement is  contemplated,  309  —  secret  reserves,  310  —  what  is  main- 
tenance, 310  —  charging  against  revenue  and  charging  to  capital,  311  — 
three  bases  of  capitalization,  312  —  the  fxmction  of  the  balance  sheet,  313 

—  the  balance  sheet  and  solvency,  314  —  the  balance  sheet  as  credit  indi- 
cator, 314  —  the  balance  sheet  and  "going  values,"  315  —  application  of 
the  cost-of-duplication  basis,  315  —  its  futility,  317  —  application  of  the 
eaming-capacity  basis,  317  —  its  futility,  318  —  the  balance  sheet  and 
actual  costs,  319  —  application  of  the  actual-cost  basis,  319  —  its  value, 
320  —  actual-cost  basis  misused,  323  —  common  ground  of  the  three  bases, 
324  —  public  interest  in  capitalization,  324  —  depreciation  of  merchan- 
dise, 325  —  questions  and  problems,  326. 

XIX.  The  Disposition  of  Profits  329 

Confusion  of  cost  with  disposition  of  profits,  329  —  account  for  disposition 
of  profits,  330  —  mmierous  applications  of  profits,  331  —  reserves,  332  — 
sinking  funds,  333  —  reserve  for  sinking  fund,  334  —  summary,  336  — 
questions  and  problems,  337. 

XX.  The  Interpretation  of  Financial  Statements  339 

Uncertain  standards  for  financial  statements,  339  —  ultimate  and  immedi- 
ate solvency,  340  —  a  statement  of  assets  and  liabilities,  340  —  the  form 
of  balance  sheets,  343  —  spedal  designation  of  spedfic  items,  346  —  find- 
ing tendendes,  346  —  summary  of  balance-sheet  changes,  346  —  dassifi- 
cation  of  balance-sheet  changes,  348  —  interpreting  balance-sheet  changes, 
350  —  form  of  operating  statement,  350  —  relation  of  operating  statement 
and  balance  sheet,  351  —  relation  of  operating  statement  and  statement  of 
balance-sheet  changes,  353  —  general  effect  of  expansion,  354  —  state- 
ment of  affairs,  355  —  defidency  statement,  359  —  questions  and  prob- 
lems, 360. 


CONTENTS  XI 

XXI.  The  Effect  of  Interest  on  Values  365 

Present  value  of  future  realizations,  365  —  value  of  stocks,  366  —  good 
will,  367  —  trade  marks,  368  —  concessions,  patents,  and  copyrights,  369 
—  leaseholds,  371  —  bonds,  372  —  finding  the  value  of  a  bond,  373  —  ac- 
counting for  bonds,  375  —  bond  tables,  amortisation,  and  accumulation, 
376  —  importance  of  amortisation  and  accumulation,  378  —  profit  and 
loss  on  bond  sales,  379  —  accounting  for  issuers  of  bonds,  380  —  other 
bond  considerations,  381  —  questions  and  problems,  381. 

XXII.  Finding  the  Cost  of  Particular  Products  or  Serv- 

ices 384 

The  fundamental  requirements,  384  —  the  resulting  accounts,  385  — 
types  of  cost  finding,  386  —  finding  average  costs,  386  —  source  of  average 
costs,  387  —  finding  special  costs,  389 — direct  and  indirect  costs,  390  — 
direct  labor,  391  —  direct  material,  391 — other  direct  costs,  392 — burden 
costs,  392  —  importance  of  fair  distribution  of  burden,  392  —  general 
methods  of  distributing  burden,  393  —  labor-hour  basis,  394  —  wages 
basis,  394  —  prime-cost  basis,  395  —  other  blanket  methods,  395  —  brief 
analysis  of  burden,  396  —  the  principle  of  machine  rates,  397  —  supple- 
ments to  machine  rates,  397  —  cost  sheets  illustrated,  398  —  interest  as 
cost  of  production,  399  —  finding  costs  illustrated,  401  —  the  purpose  of 
cost  accounting,  406  —  wide  applicability  of  these  principles,  406 — ques- 
tions and  problems,  407. 

Appendices 

A.  Drafts  411 
Questions  and  problems                                                           413 

B.  Simple  Interest  and  Bank  Discount  414 
Questions  and  problems  417 

C.  Compound  Interest,  Compound  Discount,  and  Annuities  418 
Questions  and  problems  423 

D.  Single  Entry  427 
Index                                                                                     429 


THE  FUNDAMENTALS  OF 
ACCOUNTING 

CHAPTER  I         ;      ..  ,        \ 

INTRODUCTION 

An  Accountant  like  an  Editor.  The  accountant  may  be  com- 
pared in  some  respects  to  the  editor  of  a  newspaper  or  a  magazine. 
The  business  man  requires  to  be  constantly  informed  about  the 
conditions  and  operations  of  his  business,  just  as  he  requires  to  be 
informed  of  the  conditions  and  operations  of  the  business  world 
with  which  he  has  dealings.  It  is,  indeed,  more  immediately  im- 
portant that  he  shall  know  just  how  things  are  going  on  within  his 
own  business  than  it  is  that  he  shall  know  how  things  are  going  on 
outside,  for  since  his  own  business  is  under  his  direct  control,  he 
is  responsible  for  its  guidance  day  by  day,  whereas  adjustment  to 
the  outside  business  world  with  which  he  has  necessary  dealings  is 
often  a  matter  of  weeks  or  months  —  never  too  soon  begun,  but  less 
serious  if  an  error  is  made,  for  more  time  is  available  for  correc- 
tion. However  well  informed  he  may  be  about  people's  demand  for 
goods  or  for  services,  imless  he  is  conducting  his  own  business  in 
such  a  way  that  he  can  provide  goods  or  services  when  wanted,  he 
is  failing  to  conduct  business  successfully.  It  is  important,  there- 
fore, that  a  business  man  shall  be  informed  with  frequency  about 
his  own  business,  and  that  this  information  shall  cover  a  large 
variety  of  facts,  such  as  his  stock  of  goods  on  hand,  the  cost  of  that 
stock  of  goods  (whether  purchased  or  manufactured),  the  expenses 
of  conducting  his  business  (so  subdivided  that  he  can  know  whether 
his  expenses  in  any  particular  direction  are  running  higher  than 
formerly  or  are  out  of  relation  to  the  amoimt  of  business  done),  the 
amount  of  indebtedness  he  has  soon  to  pay,  the  amount  of  money 
coming  in  and  soon  to  be  available  for  paying  debts,  the  amoimt  of 
cash  in  hand,  the  amoimt  of  investment  in  his  business,  the  profits 
which  he  is  making,  and  the  availability  of  those  profits  for  with- 
drawal. 


2  THE  FUNDAMENTALS  OF  ACCOUNTING 

What  the  Accountant  Edits.  Just  as  the  editor  must  get  into  the 
hands  of  the  public  at  frequent  intervals  information  with  regard 
to  the  news  of  the  world  or  with  regard  to  some  special  field  of 
activity  or  learning,  so  the  accountant  must  get  into  the  hands  of 
the  business  man  at  reasonably  frequent  intervals  such  informa- 
tion as  has  been  enumerated.  Usually  there  are  several  persons  in 
the  employ  of  a  business  whose  task  is  in  part  to  prepare  informa- 
tion for  the  general  manager,  but  usually  such  information  is  either 
not  in  the  particular  shape  most  useful  for  the  manager  or  is  not  so 
correlated  with  other  information  as  to  bring  out  the  larger  facts 
that  the  manager  needs  to  know.  It  is  the  task  of  the  accountant 
to  put  the  information  in  the  desired  shape  and  to  correlate  various 
kinds  of  information,  or,  as  we  commonly  say,  "edit"  the  informa- 
tion. Because  the  accountant  must  prepare  information  for  the 
general  manager  or  other  officer,  he  usually  occupies  a  more  or  less 
confidential  position,  and  often  is  a  vice-president  of  a  corporation. 
He  must  have  the  knack  of  preparing  information  in  shape  for  use 
by  others,  he  must  have  sufficient  imagination  to  see  what  sort  of 
information  the  various  officials  will  desire,  and  he  must  have 
sufficient  power  of  analysis  to  see  how  to  get  the  sort  of  information 
that  will  enable  the  operating  officers  of  the  business  to  tie  up 
the  various  parts  of  the  business  with  each  other  and  with  the 
outside  business  world  —  and  he  should  provide  them  with  such 
information  even  if  they  have  not  realized  the  need  of  such  par- 
ticular information.  It  is  his  task,  in  a  sense,  to  foresee  what 
information  about  the  business  will  be  later  required  and  to  see 
that  such  information  will  be  available  at  the  proper  time.  He 
must  anticipate  the  need  for  information,  so  that  he  may  have  his 
lines  laid  before  the  occurrence  of  the  event,  for  the  procurement  of 
that  information  as  soon  as  the  event  happens.  This  is  just  the 
task  of  the  editor  of  a  newspaper  or  a  magazine,  for  he  not  only  tells 
people  what  they  already  wish  to  know,  but  he  gives  them  what 
they  are  glad  to  know,  though  they  had  not  previously  known  that 
they  needed  to  know  it. 

Many  Kinds  of  Accounting.  Just  as  there  are  various  types  of 
editors,  some  of  them  preparing  daily  news  for  the  general  public, 
some  preparing  literary  articles  for  those  who  are  interested  in 
literary  matters,  some  who  are  preparing  technical  matters  for  the 


INTRODUCTION  3 

technical  public,  so  there  are  various  types  of  accountants  who  are 
preparing  information  for  various  types  of  business  managers. 
Rarely  an  accountant  is  also  the  bookkeeper,  and  has  prepared  the 
preliminary  figures  as  well  as  edited  those  figures  and  provided 
the  editorial  matter  to  correlate  them  properly  for  the  manager. 
More  often  the  accountant  does  not  prepare  original  figures,  but 
merely  edits  the  figures  of  other  people,  combining  them  in  various 
ways  and  drawing  from  them  important  conclusions  that  only  a 
trained  person  could  see.  Many  of  the  figures  are  statistical,  not 
expressed  in  dollars  and  cents,  but  are  quite  as  important  as  finan- 
cial figures.  The  matters  of  accounting  are  almost  as  various  and 
different  in  nature  as  the  matters  which  are  pubHshed  in  news- 
papers and  magazines.  It  would  be  virtually  impossible  for  any 
man  to  prepare  himself  to  edit  all  kinds  of  newspapers  and  maga- 
zines, for  some  of  them  are  extremely  technical  and  a  man  must  be 
an  expert  in  certain  lines  of  knowledge  before  he  can  edit  a  news- 
paper in  those  technical  lines.  Similarly,  a  man  is  not  competent 
to  edit  the  records  of  a  highly  technical  business,  like  those  of  a 
chemical  works,  until  he  is  familiar  with  the  processes  of  the  chemi- 
cal plant  and  until  he  has  made  a  study  of  the  accounting  problems 
connected  with  certain  technical  operations. 

Limitations  of  Accountants.  No  effort  is  made  in  this  book  to 
take  up  more  than  a  few  of  the  technical  matters  of  accounting,  and 
such  matters  are  far  more  numerous  than  the  person  of  limited 
acquaintance  with  accounts  would  usually  suppose.  The  peculiar 
and  technical  matters  of  accounting  are  not  merely  those  made 
necessary  by  the  peculiarities  of  certain  industries:  they  are  often 
common  to  all  industries,  but  peculiar  to  certain  relations  of  busi- 
ness, such  as  peculiar  partnership  arrangements,  peculiar  cor- 
poration organization,  settlement  of  bankruptcies,  purchase  and 
sale  of  rights  where  a  long  period  elapses  between  the  purchase 
and  the  delivery,  and  agreements  in  which  various  contingencies 
are  involved.  All  these  matters  need  pecuUar  kinds  of  records  in 
order  that  at  any  time  during  the  history  of  the  transaction  or  later 
one  may  see  how  the  various  persons  concerned  in  the  transaction 
were  financially  related  to  it.  In  an  elementary  book  it  is  unde- 
sirable to  take  up  complicated  relations,  for  no  one  is  competent  to 
understand  them  and  to  make  or  control  the  record  of  them  unless 


4  THE  FUNDAMENTALS  OF  ACCOUNTING 

he  is  thoroughly  familiar  by  experience  with  the  record-making  for 
more  or  less  simple  transactions  —  else  the  records  which  he  may 
make  will  confuse  the  complicated  sort  of  transaction  with  the 
transaction  which  is  of  a  more  simple  sort,  and  it  will  be  impossible 
from  the  record  to  interpret  the  actual  facts  of  the  case.  Un- 
fortunately a  great  many  persons  who  have  familiarized  them- 
selves with  the  fundamentals  of  accounts  have  thought  that  they 
had  mastered  the  whole  subject  and  have  undertaken  to  make 
record  of  transactions  which  they  did  not  at  all  understand;  and 
later,  when  a  dispute  has  arisen  regarding  the  transactions,  the 
records  have  proved  inadequate  and  have  often  led  to  wrong  settle- 
ment merely  because  the  person  who  made  the  record  pretended  to 
be  more  competent  than  he  was.  It  is  quite  as  important  that  a 
person  studying  accounts  know  what  he  does  not  understand,  and 
thus  know  what  to  avoid,  as  it  is  that  he  shall  know  how  to  do  those 
things  which  he  is  quite  sure  that  he  understands.  Just  as  one 
may  know  a  great  deal  of  law  and  yet  be  incompetent,  and  know 
one's  self  to  be  incompetent,  in  certain  complicated  and  weighty 
matters  of  law,  so  a  person  who  knows  much  of  accounting  can 
sometimes  give  best  proof  of  his  knowledge  by  indicating  frankly 
what  he  is  not  competent  to  do. 

Relation  between  Accounting  and  Bookkeeping.  It  has  been 
suggested  that  the  accountant  is  like  the  editor  in  that  he  does  not 
usually  provide  the  original  figures  on  which  he  bases  any  report. 
This  is  because  the  accountant  is  not  usually,  except  by  chance,  a 
mere  bookkeeper;  though,  like  the  editor,  he  often  directs  what 
sort  of  thing  shall  be  written  and  how  it  shall  be  written.  The  task 
of  the  bookkeeper  is  to  record  known  facts,  and  these  facts  may  be 
known  because  they  are  very  simple  and  of  an  obvious  sort,  or  they 
may  be  known  because  an  accountant  or  some  one  else  has  ana- 
lyzed a  business  transaction  and  has  told  the  bookkeeper  exactly 
what  is  the  situation  to  be  recorded.  The  task  of  the  bookkeeper, 
though  important,  does  not  ordinarily  involve  a  very  keen  analysis 
of  a  business  situation.  The  processes  of  bookkeeping,  though  re- 
quiring intelligence,  very  great  accuracy,  and  general  good  common 
sense,  are  chiefly  those  of  routine.  When  need  arises  for  analysis 
of  a  complex  situation,  or  for  statement  of  a  complex  situation  so 
that  the  record  will  be  perfectly  clear  not  only  in  itself  but  in  rela- 


INTRODUCTION  3 

tion  to  other  elements  of  a  business,  decision  is  usually  made  by  an 
accountant  who  has  had  training  in  both  the  larger  aspects  of 
figures  and  the  significance  of  business  relations.  The  task  of  the 
accountant  may  be  described  generally  as  that  of  analysis  and 
correlation  of  various  figures  so  that  the  important  facts  about  a 
business,  both  the  details  and  the  larger  meanings,  may  appear  in 
their  proper  light  and  emphasis.  Perhaps  the  best  way  to  indi- 
cate his  duty  is  by  the  common  figurative  illustration  of  the  dis- 
tinction between  seeing  the  forest  and  seeing  the  trees.  The  book- 
keeper is  bound  to  see  the  individual  tree,  as  he  makes  his  record, 
for  that  is  his  job;  but  often  he  does  not  realize  what  is  the  general 
appearance  of  the  forest  as  a  whole,  the  relation  of  the  various  kinds 
of  trees  in  the  forest  to  one  another,  and  what  is  the  relation  of  the 
forest  as  a  whole  not  only  to  the  pastures  and  the  fields  and  the 
cultivated  portions  of  the  country  in  which  it  lies,  but  also  to  the 
hills,  the  valleys,  and  the  plains.  It  is  the  duty  of  the  accoimtant 
to  see  the  forest  in  all  its  surroundings  as  well  as  in  itself,  and  he  is 
not  much  concerned  with  the  individual  trees. 

Dependence  on  Bookkeeping.  Yet  the  accountant  could  not  do 
his  work  without  the  bookkeeper,  and  the  language  which  he 
speaks  is  in  part  the  language  of  bookkeeping.  He  must,  indeed, 
understand  bookkeeping  before  he  can  be  an  accountant.  In  fact, 
an  accountant  usually  is  required  to  be  a  better  bookkeeper  than 
most  bookkeepers,  for  he  is  obliged  to  imtangle  situations  which 
have  been  unfortunately  recorded  on  the  books,  and  he  often  must 
direct  the  bookkeeping  to  serve  his  ends.  This,  on  the  other  hand, 
does  not  necessarily  mean  that  he  must  be  an  expert  in  the  tech- 
nique of  all  sorts  of  bookkeeping,  for  bookkeeping  as  a  matter  of 
fact  involves  but  very  few  principles.  Though  there  are  thousands 
of  bookkeeping  forms  all  good  in  their  way,  an  accountant  does  not 
need  to  be  familiar  with  them  all,  for  they  are  all  based  on  a  few 
fundamental  principles,  and  a  person  who  understands  those  prin- 
ciples thoroughly  is  able  to  see  how  they  have  been  applied  to  the 
various  forms  of  books  that  he  may  come  upon.  Variations  in  the 
form  of  books  are  due  almost  entirely  to  the  modem  attempt  to 
apply  labor-saving  devices,  and  since  the  circimistances  of  almost 
every  business  are  somewhat  different  from  those  of  other  busi- 
nesses, the  application  of  labor-saving  devices  in  each  will  differ  in 


6  THE  FUNDAMENTALS  OF  ACCOUNTING 

detail  from  the  application  in  others.  A  careful  examination  will 
enable  any  one  familiar  with  the  fundamental  principles  to  leam 
from  any  set  of  books  exactly  how  the  system  is  working,  and  he 
is  therefore  just  as  competent  to  interpret  those  books  and  to  pass 
judgment  upon  them  as  if  he  had  made  a  previous  special  study  of 
that  particular  form  and  had  had  the  person  who  devised  the  sys- 
tem tell  him  how  it  is  intended  to  work.  Since  an  imderstanding 
of  all  bookkeeping  principles  is  essential  to  an  accountant's  work, 
in  the  following  pages  the  fundamental  principles  of  bookkeeping 
will  be  first  discussed,  and  then  a  study  of  the  general  application 
of  labor-saving  devices  to  those  fundamental  principles  will  follow. 
Virtually  nothing  further  will  be  said  about  bookkeeping  forms. 

Accounting  for  Non-Accountants.  In  the  early  part  of  this  in- 
troduction emphasis  was  laid  upon  the  necessity  of  an  accountant's 
editing  the  figures  which  are  to  be  presented  to  a  general  manager, 
but  it  should  be  just  as  clearly  understood  that  a  business  man  as 
well  as  an  accountant  should  have  a  certain  familiarity  with  the 
interpretation  of  an  accoimtant's  figures,  for  there  is  not  uniform 
practice  with  regard  to  the  statement  of  such  figures,  and  a  man 
often  finds  it  necessary  to  interpret  the  figures  of  other  businesses 
where  the  forms  of  statement  not  only  are  entirely  imlike  his  own 
but  are  in  fact  unfortunately  chosen.  Any  man  in  an  executive 
position  in  a  business,  whether  he  has  anything  directly  to  do  with 
accounts  or  not,  and  any  man  having  dealings  with  general  busi- 
ness, as  an  investor  or  a  student  of  public  affairs,  needs  a  certain 
familiarity  with  accoimting  procedure  and  statements,  so  that  he 
may  judge  how  business  affairs,  both  public  and  private,  are  being 
conducted.  Attention  is  devoted  in  this  book,  therefore,  as  much 
to  the  interpretation  of  accounts  as  to  their  construction. 


CHAPTER  n 

DOUBLE  ENTRY  AND  THE  BALANCE  SHEET 

Basis  of  Double  Entry.  The  basis  of  double  entry  is  a  realization 
that  in  modern  business  there  are  no  assets  lying  about  without 
claimants.  To  everything  having  value  some  one  is  a  claimant. 
If  in  a  business  there  is  any  property,  or  any  right,  or  any  intangible 
quality  that  brings  value,  like  a  reputation  that  draws  trade,  some 
one  claims  that  property  or  right  or  quaHty.  If  one  is  to  have  a 
statement  of  a  business  at  any  particular  time,  therefore,  one  will 
need  to  know  exactly  what  property,  rights,  and  qualities  are  in  the 
business  and  who  may  claim  those  particular  elements  which  go  to 
make  up  the  business  as  a  whole.  We  must  distinguish,  moreover, 
one  kind  of  asset  from  another,  for  otherwise  every  time  we  con- 
template a  particular  transaction  we  might  need  to  visit  some  part 
of  the  establishment  to  learn  whether  that  transaction  is  possible 
for  the  business  as  it  now  stands  —  we  cannot  ordinarily  pay  debts 
with  equipment,  nor  seU  merchandise  if  we  have  only  raw  material, 
nor  pay  dividends  if  we  have  only  stocks  and  bonds.  Similarly  we 
must  distinguish  one  kind  of  claims  to  the  assets  from  other  kinds 
of  claims,  for  different  claims  are  enforceable  in  different  ways  and 
may  be  met  at  different  times.  Since,  however,  as  already  indi- 
cated, all  values  are  claimed  by  some  one,  it  must  follow  that  the 
total  values  attached  to  the  list  of  assets  must  equal  the  total 
claims  which  are  established  against  the  business  by  persons,  in- 
cluding the  proprietors,  whose  claims  are  recognized  by  it.  So 
even  the  simplest  statement  that  can  be  drawn  up  for  a  business 
must  be  "in  balance"  —  i.e.,  the  asset  side  will  exactly  equal  or 
balance  what  we  may  call  the  "ownership-claim"  side.  Equality 
is  always  there,  for  if  any  value  is  in  the  business  it  must  belong  to 
some  one,  and  that  ownership  must  be  recorded  both  on  the  books 
and  on  such  a  statement.  There  is  no  way  by  which  total  assets 
can  increase  without  a  parallel  increase  in  claims  to  assets;  there 
is  no  way  by  which  total  assets  can  decrease  without  a  parallel  de- 
crease in  claims  to  assets;  there  is  no  way  by  which  total  claims  to 
assets  can  increase  without  a  parallel  increase  in  assets  to  be 


8  THE  FUNDAMENTALS  OF  ACCOUNTING 

claimed;  and  there  is  no  way  by  which  total  claims  to  assets  can 
decrease  without  a  parallel  decrease  in  the  assets  to  be  claimed. 
Anything  else  would  mean  either  that  there  were  some  unclaimed 
assets,  or  that  some  one  had  a  claim  to  property  which  did  not 
exist.  Either  is  absurd.  The  assets  determine  (fix  a  limit  to)  the 
ownership-claims.  This  does  not  mean,  of  course,  that  a  person 
may  not  present  a  claim  for  property  when  there  is  not  property 
enough  to  satisfy  his  claim,  as  in  the  case  of  a  bankruptcy,  and  often 
a  person  claims  property  which  some  one  else  at  the  same  time 
claims.  In  such  cases  some  of  the  claims  are  not  enforceable  or 
real  claims,  and  it  is  either  the  task  of  a  bookkeeper  to  show  the 
reduction  of  claims  to  match  the  assets,  or  the  task  of  a  lawyer  or  a 
judge  to  settle  the  rival  claims. 

Balance  Sheet.  A  simple  illustration  of  such  a  statement,  which 
is  commonly  called  a  "balance  sheet,"  is  attached  below.  It  is 
customary  in  America  for  all  assets  to  appear  on  the  left  side  of 
such  a  statement  —  ownership-claims  at  the  right. 


Assets 

Ownership-claims 

Real  Estate 

$50,000 

Proprietor                          $92,000 

Fixtures 

2,000 

Accounts  Payable                45,ooo 

Accounts  Receivable 

SS,ooo 

Merchandise 

25,000 

Cash 

5,000 
$137,000 

$137,000 

Assets.  All  items  on  the  assets  side  above  except  accounts  re- 
ceivable represent  assets  which  can  be  valued  or  counted  by  ob- 
servation. Accoimts  receivable  does  not  represent  tangible  prop- 
erty in  the  ordinary  sense,  but  represents  claims  of  this  business 
against  outside  people  for  merchandise  purchased  from  the  busi- 
ness in  some  past  period.  These  may  be  reported  either  individu- 
ally by  name,  or  in  a  group  as  above.  The  statement  is  not  a  com- 
plete balance  sheet  unless  it  covers  all  the  items  of  value  belonging 
to  the  business. 

Ownership-Claims.  Even  though  the  business  is  owned  by  one 
man,  the  proprietor,  he  is  not  necessarily  the  owner  of  all  the  prop- 
erty shown  on  the  left-hand  side  of  the  statement;  for  usually  a  man 
conducts  business  with  other  capital  than  his  own.  In  that  case, 
though  the  people  who  have  lent  him  money  cannot  without  special 


DOUBLE  ENTRY  AND  THE  BALANCE  SHEET      9 

legal  provision  step  in  and  carry  off  any  of  the  assets  on  the  ground 
that  a  part  of  the  business  belongs  to  them,  it  is  nevertheless  true 
that  they  have  a  claim  against  those  assets  independent  of  the 
proprietor's  ownership.  In  order  to  indicate  the  fact  that  a  pro- 
prietor is  not  the  sole  and  unhampered  owner  of  the  property  on 
the  left-hand  side  of  the  sheet,  it  is  necessary  either  to  show  the 
names  of  other  people  who  have  claims  against  the  property,  or  to 
show  the  total  claim  of  all  such  persons,  in  a  group  or  in  several 
groups  according  to  the  nature  of  their  claims,  and  this  must  be 
done  for  two  reasons  —  first,  to  show  how  much  of  the  ownership 
actually  belongs  to  the  proprietor,  and,  second,  to  show  how  much 
of  the  assets  must  sooner  or  later  be  turned  over  to  the  creditors  of 
the  business  in  order  to  satisfy  their  claims.  In  the  case  of  the 
balance  sheet  above,  the  accounts  payable,  being  just  the  reverse  of 
the  accounts  receivable  on  the  other  side,  represents  sums  payable 
by  the  business  to  outsiders  who  have  furnished  merchandise.  It 
may,  indeed,  happen  that  these  outsiders  cannot  immediately  claim 
payment  of  the  sums  which  are  owed  them :  it  may  be  that  the  mer- 
chandise was  bought  under  terms  of  credit — specifically,  that  the 
debts  must  be  paid  in  ten,  or  thirty,  or  sixty  days.  Only  through 
legal  process  can  the  holders  of  the  accounts  payable  force  a  distri- 
bution of  the  assets  to  them  if  the  proprietor  withholds  payment. 

Temporary  Validity  of  Balance  Sheet.  An  important  thing  to 
note  about  a  balance  sheet  is  that  it  will  normally  hold  true  for 
only  a  very  brief  moment  of  time.  If  the  business  is  continuing, 
the  very  first  hour  of  the  next  day  it  is  probable  that  something  will 
happen  to  change  some  of  the  figures  given  here.  If  any  payment 
of  debt  is  made,  cash  will  be  less  than  before,  and  accoimts  payable 
will  be  less  than  before.  If  any  merchandise  is  sold,  the  mer- 
chandise will  be  less  and  the  accounts  receivable  will  be  more,  or 
the  cash  will  be  more;  and  if,  as  is  of  course  usual,  merchandise 
is  sold  at  a  profit,  the  new  figure  of  cash  or  accounts  receivable 
will  be  larger  than  the  figure  for  the  merchandise  surrendered  for 
it.  In  other  words,  the  change  in  the  character  of  the  assets  from 
merchandise  to  accounts  receivable  or  cash  brings  not  an  exact 
equivalent  in  exchange,  but  in  addition  a  new  or  excess  asset,  aris- 
ing from  profit,  and  that  profit  in  turn  constitutes  increased  pro- 
prietorship or  ownership-claim. 


10  THE  FUNDAMENTALS  OF  ACCOUNTING 

Balance  Sheet  always  in  Balance.  Our  next  fundamental  matter 
to  note  about  accounts  is  that,  just  as  our  balance  sheet  showed 
assets  and  what  we  may  call  ownership-claims  to  be  equal,  no 
change  that  can  later  occur  in  any  part  of  the  business  or  from  any 
cause  can  destroy  that  equality  —  and  it  existed  from  the  begin- 
ning of  the  business.  It  is  inherent  in  the  constitution  of  business. 
Let  us  examine  this. 

Blinds  of  Changes  in  Assets.  There  are  four  and  only  four  types 
of  soiurces  from  which  a  business  can  get  assets: 

(i)  Investment  by  the  owner  of  the  business 

(2)  Loans  made  to  the  business 

(3)  Exchanging  an  old  asset  for  a  new 

(4)  Profit  accruing  to  the  business 

This  is  one  of  the  axiomatic,  common-sense  things  that  one  must 
see  early  in  his  study  of  accounting.  Obviously  an  asset  must 
come  either  from  inside  the  business  or  from  outside  —  for  there 
are  no  other  places:  if  the  new  asset  comes  from  outside  the  busi- 
ness, it  must  come  either  from  an  owner  of  the  business  or  from  one 
who  is  not  an  owner,  for  there  are  no  others;  if  it  comes  from  an 
owner,  the  case  is  that  of  the  first  type  Usted  above  (investment) ; 
if  from  one  who  is  not  an  owner,  the  case  is  of  the  second  type  (loan 
to  the  business) ;  if  it  comes  from  inside  the  business,  it  must  come 
either  from  what  was  there  before  or  from  what  was  not  there  be- 
fore; if  the  new  asset  is  derived  from  an  asset  that  was  in  the  busi- 
ness before,  it  comes  by  exchange,  which  is  the  third  type  named 
above;  if  it  comes  from  inside  the  business  but  from  something  not 
there  before,  it  must  have  been  created  inside  and  is  of  the  fourth 
type  (and  that  is  just  what  we  mean  by  profits).  This  gives  us  our 
four  sources.  Similarly  there  are  only  four  causes  of  reduction  of 
assets:  (i)  withdrawal  of  investment  by  an  owner  of  the  business, 
(2)  repayment  to  a  lender,  (3)  giving  one  asset  in  exchange  for  an- 
other, and  (4)  loss  suffered  by  the  business.  The  interesting  thing 
about  these  four  sources  of  assets,  and  about  these  contrary  causes 
of  reduction  of  assets,  is  that  any  proper  accounting  must  not  only 
record  them,  but  record  them  as  distinct  from  each  other.  We 
must  distinguish  proprietor's  claim  from  lender's  claim,  of  course, 
for  the  proprietor  is  entitled  to  all  growth  in  assets  (as  well  as  re- 
quired to  suffer,  if  possible,  all  shrinkage),  whereas  the  lender  has  a 


DOUBLE  ENTRY  AND  THE  BALANCE  SHEET  II 

claim  for  a  fixed  sum  only.  We  must  distinguish  the  amount  of  the 
proprietor's  investment  from  the  amount  of  his  profits,  of  course, 
for  otherwise  he  will  not  know  how  he  is  prospering.  We  have  al- 
ready seen  that  we  must  distinguish  one  kind  of  asset  from  another. 

Two  Aspects  of  Changes  —  Assets.  We  saw  some  time  ago  that 
the  existence  of  assets  must  be  shown  on  the  records,  each  kind 
separately,  and  we  have  now  just  seen  that  all  sources  of  assets  and 
all  causes  of  reduction  in  assets  must  also  be  shown  on  the  records. 
If  we  have  more  cash,  for  example,  we  need  to  record  not  only  the 
change  in  the  cash,  but  also  the  fact  that  the  proprietor  invested 
it,  or  that  a  profitable  transaction  yielded  it,  or  that  some  one  lent 
it,  or  that  we  exchanged  some  other  asset  for  it.  The  reverse  is 
true,  of  course,  of  the  disappearance  of  assets.  We  find,  then,  that 
(with  the  exception  of  exchange  of  one  asset  for  another  of  the 
same  kind,  as  a  ten  dollar  bill  for  two  fives,  or  one  article  of 
merchandise  for  another)  a  change  in  any  asset,  whether  increase 
or  decrease,  must  be  recorded  in  double  aspect  —  the  effect  of  the 
change,  in  the  record  of  the  asset  itself,  and  the  reason  for  the 
change,  in  the  record  of  the  thing  which  brought  about  or  cooper- 
ated in  that  change. 

Two  Aspects  of  Changes  —  Ownership-Claims.  Approaching 
these  changes  from  the  ownership-claim  end,  too,  we  find  the  same 
necessity  for  the  double-aspect  record.  A  lender  cannot  lend  with- 
out lending  something;  and  hence  it  is  inconceivable  that  we  should 
record  a  person  as  a  lender  without  also  recording  the  thing  that  he 
lent.  The  same  is  true  of  investment  by  the  proprietor:  he  cannot 
invest  without  investing  something;  and  that  something  must  be 
recorded  as  an  asset  quite  as  much  as  the  fact  of  his  investment 
must  be  recorded  in  coimection  with  his  name.  Lastly,  even  profit 
and  loss  are  inconceivable  except  in  a  double  aspect:  no  man  can  be 
richer  without  being  richer  in  something;  if  he  has  not  more  cash, 
or  more  merchandise,  or  more  collectible  accounts,  or  more  other 
property,  or  fewer  debts,  he  is  not  richer;  if  you  can  record  more 
worth  in  connection  with  his  name,  you  can  record  either  more 
assets  or  fewer  debts.  If  his  profit  lies  in  the  fact  that  he  has  fewer 
debts,  one  ownership-claim  (his)  has  been  substituted  for  another 
(the  creditor's),  and  the  change  in  each  needs  record.  For  propri- 
etorship withdrawals  of  investment,  for  payments  to  lenders,  and 


12  THE  FUNDAMENTALS  OF  ACCOUNTING 

for  losses,  of  course,  the  same  principle  is  true  —  if  the  claims  are 
reduced,  the  assets  which  were  used  to  pay  them  are  also  reduced. 
Just  as  we  find,  then,  that  it  is  impossible  to  have  an  asset  affected 
without  an  effect  on  the  proprietor's  record,  or  the  profit  and  loss 
record,  or  a  lender's  record,  or  the  record  of  some  other  asset,  so  we 
'find  that  it  is  impossible  to  affect  the  proprietor's  record,  or  any 
other  ownership-claim  record,  without  an  effect  on  an  asset  record 
(except,  of  course,  in  case  of  an  exchange  of  ownership-claims,  as  a 
substitution  of  one  claim  for  another  —  not  changing  the  total  of 
ownership-claims,  and  so  not  changing  the  assets  to  which  they  are 
claims). 

Balance  in  all  Transactions.  In  other  words,  we  have  seen  that 
just  as  a  balance  sheet  must  always  be  in  balance,  with  equality  of 
assets  and  ownership-claims,  the  record  of  subsequent  transactions, 
whether  they  are  large  or  small,  of  whatever  sort,  must  continue 
that  equaUty  —  not  only  all  in  all  and  in  the  long  run,  but  for  each 
transaction  individually,  for  we  have  found  this  principle  true  of 
all  possible  transactions.  This  may  be  tabulated  so  as  to  show  for 
every  possible  change  the  four  possible  sources  or  causes  which 
require  record  as  much  as  do  the  changes  first  named. 

(i)  Increase  of '  asset  —  from  proprietor,  from  profitable  transac- 
tions, from  borrowing,  from  exchange 

(2)  Giving  up  of  asset  —  to  the  proprietor,  in  unprofitable  trans- 
actions, to  lenders,  in  exchange 

(3)  Increase  of  ownership-claim  —  through  investment  by  proprie- 
tor, making  a  profit,  borrowing,  exchange 

(4)  Decrease  of  ownership-claim  —  through  withdrawal  by  proprie- 
tor, losing,  paying  a  lender,  giving  in  exchange 

It  will  be  observed  that  (except  for  the  exchange  items  which  apply 
only  within  a  group)  whatever  is  (i)  above  is  also  (3),  and  must  be 
recorded  in  both  aspects;  and  whatever  is  (2)  is  also  (4),  and  must 
so  be  recorded.  This  is  the  essence  of  double  entry.  Every  entry 
has  an  "other  half,"  which  gives  the  other  aspect  of  the  same 
transaction. 

Assets  Determining  Ownership-Claims.  The  conditioning  ele- 
ment is  the  assets,  for  they  are  real  and  determine  the  ownership- 
claims  (for  there  can  be  no  claim  to  what  does  not  exist).  Since 
there  can  be  no  increase  in  ownership-claims  without  an  increase  in 


DOUBLE  ENTRY  AND  THE  BALANCE  SHEET     I3 

assets,  there  must  be  no  record  of  increase  of  ownership  unless  there 
is  at  the  same  time  a  record  of  increase  of  assets,  and  conversely 
there  must  be  no  record  of  decrease  of  ownership  imless  there  is  at 
the  same  time  decrease  of  assets  (for  if  the  assets  are  there  the 
ownership  is  there).  To  say,  however,  that  increase  of  ownership 
means  increase  of  assets,  and  decrease  of  ownership  means  decrease 
of  assets,  is  not  to  say  that  entry  to  ownership  provides  or  destroys 
assets,  but  is  to  say  that  such  entry  must  never  be  made  imless  the 
correlative  thing  has  happened  —  and  the  entry  on  proper  books  is 
to  show  that  it  has  happened.  But  an  entry  increasing  certain 
specific  ownership-claims  may  be  made  without  increase  in  assets, 
for  it  may  go  along  with  a  decrease  in  other  ownership-claims  — 
which  leaves  total  ownership-claims  unchanged. 

Balance-Sheet  Illustrations.  This  may  well  be  illustrated  by  a 
series  of  successive  balance  sheets,  supposing  that  we  draw  up  a 
new  balance  sheet  after  each  transaction. 

Suppose  you  and  I  begin  business  as  equal  partners  with  $10,000 
in  cash.    Then  our  balance  sheet  stands  as  follows: 

1.  Cash  $10,000       Proprietorship-claim        $10,000 

This  is  the  simplest  possible  type  of  balance  sheet  —  a  single  asset 
and  a  single  ownership-claim  to  complete  the  record  of  it  —  the 
two  aspects  of  the  same  fact. 
Then  suppose  we  buy  oJQ&ce  furniture  with  part  of  our  cash. 

2.  Cash  $9,000       Proprietorship-claim       $10,000 
Office  Furniture  1,000 

$10,000  $10,000 


This  merely  substitutes  a  new  asset  for  a  part  of  the  old  —  an  ex- 
change of  asset  without  a  change  in  total  assets,  and  therefore 
without  a  change  in  ownership-claim;  but,  like  all  other  transac- 
tions, it  involves  two  changes  (in  this  case  an  increase  of  one 
account  and  a  decrease  of  another). 
Now  we  buy  $5,000  of  merchandise  "on  account." 

3.        Cash                            $9,000  Proprietorship-claim        $10,000 

Office  Furniture           1,000  Accoimts  Payable  claim     5,000 
Merchandise                 5,000 

$15,000  $15,000 


14  THE  FUNDAMENTALS  OF  ACCOUNTING 

This  adds  two  new  elements  —  a  new  asset  without  exchange  of 
the  old,  and  a  new  ownership-claim;  and  it  must  have  both  of  these 
if  either,  for  the  new  asset  must  have  an  owner  somewhere.^ 

Now  we  give  our  promissory  notes  for  $2,000  to  some  of  our 
creditors,  as  a  way  of  acknowledging  formally,  through  negotiable 
instruments,  our  debt  for  the  merchandise. 

4.  Cash  $9,000  Proprietorship-claim  $10,000 
OflSce  Furniture  1,000  Accounts  Payable  claim  3,000 
Merchandise                 5,000      Notes  Payable  claim  2,000 

$i5>ooo  $i5>ooo 

This  substitutes  a  new  ownership-claim  for  an  old  —  a  claim  indi- 
cated by  notes  for  a  claim  indicated  by  a  "book  account."  This 
illustration  may  further  exempUfy  changes  in  ownership-claim  if 
we  suppose  an  intermediate  step  to  be  taken:  the  proprietor,  in- 
stead of  giving  promissory  notes  to  his  creditors,  as  assumed  above, 
may  give  his  notes  to  a  bank  in  exchange  for  cash  and  give  the  cash 
to  his  creditors.  If  he  were  to  do  so,  the  balance  sheet  would  be 
just  the  same  as  that  given  above.  In  that  case,  however,  the 
three  ownership-claims  shown  would  stand  not  only  for  three  kinds 
of  ownership-claims,  but  for  three  separate  groups  of  people  hold- 
ing those  claims.  In  either  case,  however,  the  fourth  balance  sheet 
as  compared  with  the  third  shows  no  change  in  total  assets,  and  no 
change  in  total  ownership-claims;  but  it  does  show  a  change  in  the 
distribution  of  ownership-claims;  and  it  involves  two  changes  —  an 
increase  in  one  account  and  a  decrease  in  another. 

Now  we  sell  merchandise,  that  cost  us  $3,000,  for  $4,000  in  cash, 
reducing  our  merchandise  by  $3,000,  increasing  our  cash  by  $4,000, 
and  showing  a  new  proprietorship  profit-claim. 

5.  Cash  $13,000  Proprietorship  (investment)  $10,000 
Office  Furniture  1,000  Accounts  Payable  3,000 
Merchandise                 2,000     Notes  Payable  2,000 

Proprietorship  (profit)  1,000 

$16,000  $16,000 


This  gives  us  a  quadruple  change:  an  exchange  of  one  type  of  asset 

*  It  will  be  remembered  that  the  creditor  has  no  legal  claim  to  these  specific  as- 
sets (except  under  certain  legal  conditions),  but  he  has  a  newly  established  claim  to 
some  assets  of  the  business  (which  particular  assets  will  be  determined  by  later  de- 
velopments). 


DOUBLE  ENTRY  AND  THE  BALANCE  SHEET     1 5 

for  another  (merchandise  for  cash  —  which  alone  would  not  affect 
the  total  of  either  assets  or  ownership-claims) ;  and  an  increase  of 
total  assets  —  for  cash  was  received  in  excess  of  the  cost  of  the 
merchandise;  and  this,  in  turn,  involves  an  increase  in  ownership- 
claim —  profit  added  to  proprietorship,  but  shown  separately. 
Only  three  changes  appear  on  the  balance  sheet,  but  that  in  cash  is 
really  double,  for  $3,000  of  the  increase  in  cash  is  from  the  exchange 
of  the  merchandise  and  $1,000  is  from  profit. 
Next  we  use  part  of  our  cash  to  pay  our  notes  payable. 

6.  Cash  $11,000  Proprietorship  (investment)  $10,000 
Office  Furniture  1,000  Accounts  Payable  3,000 
Merchandise             2,000  Proprietorship  (profit)  1,000 

$14,000  $14,000 

This  gives  a  new  type  —  the  reduction  of  both  assets  and  owner- 
ship-claims; and  of  course  they  must  go  together,  for  if  assets  have 
gone  without  replacement  by  other  assets,  ownership  has  disap- 
peared also. 

Now  we  will  suppose  that  a  change  of  style  in  merchandise  forces 
us  to  sell  our  remaining  merchandise  for  $500  in  cash. 

7.  Cash  $11,500  Proprietorship  1  $9,500 
Office  Furniture        1,000    Accounts  Payable  3,000 

$12,500  $12,500 

This  also  gives  a  reduction  in  assets,  but  here,  though  of  course  the 
disappearance  of  assets  is  accompanied  by  a  reduction  of  owner- 
ship-claims, the  reduction  of  ownership  results  not  from  the  pay- 
ment of  claims,  but  from  the  annihilation  of  them.  Business  con- 
ditions have  destroyed  $1,500  worth  of  value,  and  hence  have 
destroyed  not  only  what  was  previously  proprietors'  gain,  but 
also  $500  of  the  original  investment.  Cash  has  increased,  to  be 
sure,  but  merchandise  has  been  reduced  by  much  more  than  an 
equivalent.  This  gives  four  changes  —  $1,500  decrease  of  assets, 
shown  in  two  accounts,  and  $1,500  decrease  of  ownership-claims, 
shown  in  two  accoimts. 
Lastly,  you  withdraw  from  the  business,  taking  in  cash  your 

*  For  reasons  to  be  given  later,  this  consolidation  of  investment  and  profit  into 
one  item,  for  the  purpose  of  registering  a  loss,  would  not  in  practice  be  usually  de- 
sirable, but  for  the  purpose  of  illustration  here  it  is  unobjectionable. 


l6  THE  FUNDAMENTALS  OF  ACCOUNTING 

share,  but  I  continue  alone.  The  balance  sheet  of  the  business  will 
then  appear  as  follows: 

8.        Cash  $6,750        Proprietorship  $4, 7  50 

Office  Furniture  1,000       Accounts  Payable  3,000 

$7>75o  $7>75o 

This  last  case  gives  us  again  a  reduction  in  assets,  and  in  proprietor- 
ship, but  here  is  no  loss  of  value.  One  of  the  proprietors  as  an  in- 
dividual has  received  what  the  business  has  given  up. 

All  Types  of  Changes.  These  eight  changes  are  typical  of  all  the 
changes  that  can  occur  in  business,  as  indicated  on  page  12.  To 
put  them  in  tabular  form: 


Individual  assets  increased  from: 

See  balance  sheet: 

Proprietors'  investment 

#1 

Profitable  transactions 

#5 

Borrowing 

#3 

Exchange  of  assets 

#2  (office  furniture) 

Individual  assets  reduced  by: 

See  balance  sheet: 

Withdrawal  by  proprietor 

#8 

Unprofitable  trRnsactions 

#7 

Payment  to  lenders 

#6 

Exchange 

#2  (cash) 

Individual  ownership-claims  increased  by: 

See  balance  sheet: 

Investment 

#1 

Profit 

#5 

Lending  (lending  to,  borrowing  by,  the  business) 

1      #3 

Exchange 

#4  (notes  payable) 

Individual  ownership-claims  decreased  by: 

See  balance  sheet: 

Withdrawal  of  investment 

#8 

Loss 

#7 

Payment  of  debt 

#6 

Exchange 

#4  (accounts  payable) 

Double  Aspect.  It  has  been  noted  in  the  table  above,  of  course, 
that  each  balance  sheet  is  named  twice.  This  is  because  every 
transaction  has  a  double  aspect,  and  hence  no  balance  sheet  can 
ever  record  one  change  only  ■ —  one  change  on  a  balance  sheet 
would  show  what  assets  had  increased  or  decreased,  but  would 
not  show  whose  assets  they  were  or  where  they  came  from,  or  it 
would  show  who  had  more  or  fewer  claims,  but  would  not  show 
how  those  claims  came  about  or  how  they  happened  to  be  can- 
celled; and  double  entry  gives  both  aspects  of  every  transac- 


DOUBLE  ENTRY  AND  THE  BALANCE  SHEET  IJ 

tion.    The  illustrations  above  may  now  be  tabulated  completely 
as  follows: 

Sheei  Assets  Ownership-claims 

#  I  Increased  from  Increased  (proprietors'  investment) 

#  2  One  increased,  one  decreased  

#  3  Increased  from  Increased  (payables) 

#4     One  increased,  one  decreased 

„     (  One  increased,  one  decreased    

X  Increased  from        Increased  (proprietors'  profit) 

#  6     Decreased  by         Decreased  (payables) 

„     (  One  increased,  one  decreased    

#  '  ( Decreased  by         Decreased  (proprietors'  loss) 

#  8     Decreased  by  Decreased  (proprietors'  investment) 

Summary  of  Entries.    These  may  still  further  be  summarized, 
this  time  by  ultimate  nature,  as  follows: 

(a)  When  total  assets  are  increased, 

total  ownership-claims  are  increased  (i,  3,  5) 

(b)  When  total  assets  are  decreased, 

total  ownership-claims  are  decreased  (6,  7,  8) 

(c)  When  individual  assets  are  increased  but  not  total  assets, 

some  other  assets  are  decreased,  and  total  ownership-claims 
are  not  affected  (2) 

Conversely 

(d)  When  total  ownership-claims  are  increased, 

total  assets  are  increased  (i,  3,  5) 

(e)  When  total  ownership-claims  are  decreased, 

total  assets  are  decreased  (6,  7,  8) 

(f)  When  individual  ownership-claims  are  increased,  but  not  the 

total, 
some  other  ownership-claims  are  decreased,  and  total  asset» 
are  not  affected  (4) 

One  more  boiling-down  of  these  items  is  worth  while: 

An  increase  in  any  asset  is  always  accompanied  by  (because  only  so 
can  it  be  explained)  an  increase  in  some  ownership-claim  (i,  3,  5) 
or  a  decrease  in  some  other  asset  (2) 

A  decrease  in  any  asset  is  always  accompanied  by  (because  only  so 
can  it  be  explained)  a  decrease  in  some  ownership-claim  (6,  7,  8) 
or  an  increase  in  some  other  asset  (2) 

An  increase  in  any  ownership-claim  is  always  accompanied  by  (be- 
cause only  so  can  it  be  explained)  an  increase  in  some  asset  (i,  3, 5) 
or  a  decrease  in  some  other  ownership-claim  (4) 


1 8  THE  FUNDAMENTALS  OF  ACCOUNTING 

A  decrease  in  any  ownershipHclaim  is  always  accompanied  by  (be- 
cause only  so  can  it  be  explained)  a  decrease  in  some  asset  (6,  7,  8) 
or  an  increase  in  some  other  ownership-claim  (4) 

Entries  True  of  any  Business  Organization.  Though  the  illustra- 
tions of  double  entry  as  given  here  are  confined  to  a  business  having 
individual  proprietorship,  the  same  thing  will  be  true  though  the 
business  be  owned  by  many  partners  or  by  a  corporation.  The 
names  of  the  various  accounts  representing  proprietorship  will  be 
different,  but  the  same  principles  will  apply,  as  will  be  seen  later. 

Business  as  an  Entity.  There  is  another  general  approach  to  the 
method  of  double  entry,  substituting  for  the  idea  of  constantly 
changing  proprietorship,  with  each  gain  or  loss,  the  idea  of  the 
business  as  an  entity  independent  of  its  owners.  Thinking  of  the 
business  as  owned  by  an  individual,  by  partners,  or  by  an  organiza- 
tion of  shareholders,  on  one  hand,  and  thinking  of  it  as  an  entity,  in- 
dependent of  the  owners,  on  the  other,  give  the  same  handling  of  the 
accounts.  When  the  business  is  treated  as  an  entity,  the  accounts 
of  the  proprietor,  of  the  partners,  of  the  stockholders,  represent  in  a 
sense  liabilities  of  the  business  to  the  owners  at  the  beginning  of 
any  period  as  if  owners  were  outsiders;  and  then  any  changes  in  the 
net  value  of  the  business  as  a  whole  are  carried  in  accounts  repre- 
senting increase  or  decrease  in  net  value  during  that  period  as  if  the 
business  had  no  owner,  or  were  an  independent  entity.  When  the 
earning  period  is  closed,  however,  the  entity  of  the  business  has  a 
settlement  with  the  owners,  and  the  profits  and  losses  are  carried  to 
the  accounts  of  the  owners,  to  whom  the  business  is  liable.  In  a 
sense,  therefore,  when  the  business  is  treated  as  an  entity  it  may  be 
said  to  make  a  fresh  start  at  the  beginning  of  every  financial  period, 
and  then  the  owners,  so  far  as  the  books  are  concerned,  stand 
*^ hands  off"  during  that  period;  but  at  the  close  of  the  period  the 
results  of  the  period^s  business  are  entered  in  the  accounts  of  the 
owners  once  more,  and  again  the  business  as  an  entity  makes  a 
fresh  start. 

QUESTIONS  AND  PROBLEMS 

X.  Is  it  possible  to  tell  from  the  balance  sheet  given  in  Question  8  below 
how  much  merchandise  has  been  handled  during  the  period  prior  to  the 
balance  sheet?  how  many  sales  have  been  made? 

3.  What  would  be  the  ef  ect,  on  the  balance  sheet  of  a  business,  of  donating 


DOUBLE  ENTRY  AND  THE  BALANCE  SHEET  I9 

an  unused  small  building  and  the  land  on  which  it  stands  to  an  inde- 
pendent cooperative  store  conducted  by  employees  of  the  business? 

3.  Give  an  illustration  of  pa)dng  a  debt  by  means  of  the  creation  of  a  new 
debt  (a)  when  the  change  would  affect  the  balance  sheet,  and  (b)  when 
it  would  not  affect  the  balance  sheet. 

4.  Is  it  possible  to  tell  from  the  balance  sheet  given  in  Question  8  below 
whether  the  accounts  payable  were  incurred  for  the  specific  merchan- 
dise included  among  the  assets? 

5.  In  case  of  the  unexplained  disappearance  of  an  asset,  and  the  abandon- 
ment of  hope  of  recovery,  can  the  books  be  kept  in  balance?  If  so, 
how?  If  not,  why  not? 

6.  Give  an  illustration  of  settlement  with  a  retiring  partner  for  his  owner- 
ship-claim without  the  immediate  reduction  of  any  assets  on  the  bal- 
ance sheet  and  supposing  no  losses  to  have  occurred. 

7.  The  following  is  the  balance  sheet  of  the  business  of  A  who  has  invested 
money  and  is  about  to  begin  operations: 

Cash       $5,000  Proprietor  A  $5,000 

Show  how  the  balance  sheet  will  look  after  the  following  transactions: 
A  buys  merchandise  for  cash,  $1,000,  and  fixtures  for  cash,  $1,800.    He 
buys  on  account  merchandise  for  $2,000.    He  admits  B  as  a  partner 
on  equal  terms  with  himself  on  B's  investing  $5,000  worth  of 
chandise. 

8.  The  balance  sheet  of  B,  C  &  Company  is  as  follows: 

Cash  $  3,000  Proprietor  B  $10,000 

Merchandise  8,000  Proprietor  C  10,000 

Accounts  Receivable  12,000  Accounts  Payable  3,500 

Fixtures  500 


$23,500  *  $23>5oo 

Show  the  new  balance  sheet  after  the  following  transactions:  * 

B  withdraws  $500  in  cash  for  his  personal  use. 
Accounts  payable  are  paid,  $1,000. 
Accounts  receivable  are  paid,  $4,000. 
Merchandise,  $6,000,  is  bought  on  account. 
Accounts  payable,  $3,000,  are  paid. 
Accounts  receivable,  $5,000,  are  paid. 
Merchandise  costing  $2,000  is  sold  for  cash,  $2,500. 

*  The  easiest  way  of  working  out  this  problem  is  to  copy  the  balance  sheet,  as 
given,  with  ample  space  on  the  two  margins  of  the  sheet,  and  then  to  indicate  the 
changes  in  each  item  by  placing  in  the  margins  the  amounts  of  change  (with  plus 
and  minus  signs)  opposite  the  name  of  the  appropriate  accounts.  Then  the  consoli- 
dation of  the  new  items  with  the  old  will  give  the  final  balance  sheet.  [This  is  not 
bookkeeping  method,  but  it  will  show  the  student  the  need  of  a  bookkeeping 
method  to  be  described  later-l 


CHAPTER  m 

THE  FUNDAMENTAL  PRINCIPLE  OF  DEBIT  AND  CREDIT 

Definition  of  an  Account.  The  various  sorts  of  information  so 
far  as  they  can  be  expressed  in  financial  figures,  i.e.,  dollars  and 
cents,  are  kept  in  what  are  called  "accoimts"  —  and  the  word 
has  a  specific  meaning  as  well  as  the  larger  generic  meaning  applied 
to  accounting  and  bookkeeping  as  a  whole.  In  the  specific  sense, 
an  account  is  a  classified  arrangement  of  all  the  financial  items  per- 
taining to  one  kind  of  information  about  a  business,  and  that  in- 
formation may  be  concerned  with  the  relations  of  the  business  to  an 
individual,  as  the  proprietor  or  a  lender,  or  it  may  be  concerned 
with  property,  as  cash  or  merchandise.  The  name  of  the  account 
indicates  the  sort  of  information  comprised  under  it.  The  form  of 
the  account  is  varied;  but  the  essence  of  an  account  Hes  in  the  fact 
that  it  deals  with  one  kind  of  information  only,  that  it  covers  all 
financial  information  on  that  subject  for  the  period  of  time  which  it 
is  meant  to  cover,  and  the  net  figure  of  the  accoimt  at  any  time  repre- 
sents the  net  financial  status  of  the  business,  at  that  time,  in  re- 
spect to  the  matter  indicated  by  the  title  of  the  account.  If,  there- 
fore, the  form  provides  clear  means  of  showing  increases  and  de- 
creases in  the  financial  figures  for  which  the  account  stands,  and 
provides  also  for  showing  the  balance,  or  net  standing  of  the  ac- 
count, it  has  served  its  purpose.  Increases  and  decreases  in  an 
account  are  a  means  not  only  of  obtaining  the  balance  at  any  time, 
but  of  showing  the  volume  of  transactions  for  any  period.  In- 
creases and  decreases  are  shown  through  what  are  called  ^'debits" 
and  "credits." 

Need  for  Bookkeeping  Device  to  Record  Change.  We  have  now 
observed  that  many  individual  facts  about  business  need  record: 
for  example,  in  order  to  show  all  the  facts  about  each  important 
aspect  of  a  business,  separate  accounts  are  kept  for  each  such  as- 
pect, and  these  accoimts  consist  of  financial  figures  arranged  so  as 
to  show  all  increases,  all  decreases,  and  to  provide  for  showing  the 
balance  or  status  at  any  time;  two  general  types  of  accounts  are 
kept  —  assets,  and  ownership-claims;  any  change  in  the  total  of 


FUNDAMENTAL  PRINCIPLE  OF  DEBIT  AND  CREDIT     21 

assets  requires  a  corresponding  change  in  the  total  of  ownership- 
claims  —  for  no  assets  in  business  can  be  unowned  and  no  one  can 
be  the  owner  of  property  that  does  not  exist;  some  transactions 
may  take  place  without  affecting  the  total  of  either  assets  or  owner- 
ship-claims —  for  assets  may  be  exchanged  one  for  another,  with- 
out affecting  the  total  of  assets,  and  then  ownership  is  not  affected, 
and  ownership-claims  may  be  exchanged  without  affecting  the 
total  of  such  claims,  and  then  assets  are  not  affected;  assets  and 
ownership-claims  are  subdivided  into  groups,  and  hence  it  must 
follow  that  an  exchange  of  an  asset  in  one  group  for  one  in  another 
group,  or  an  exchange  of  an  ownership-claim  in  one  group  for  one 
in  another  group,  involves  a  change  on  the  balance  sheet  in  both 
the  increased  group  and  the  decreased  group.  In  other  words,  any 
change  on  the  balance  sheet  affecting  any  item  affects  also  some 
other  item  —  on  the  principle  of  double  entry  discussed  in  Chap- 
ter n.  It  now  becomes  obvious  that  with  constant  transactions, 
many  hundred  a  day  in  active  businesses,  some  means  other  than 
the  constant  making  of  changes  in  balance-sheet  figures  is  necessary 
for  rapid  and  accurate  work.  This  means  the  need  of  a  device  or 
bookkeeping  method  for  recording  all  changes  in  such  a  way  that, 
with  the  minimum  labor  of  original  entry,  the  ultimate  result  not 
only  on  the  balance  sheet  but  on  the  statement  of  volume  of  trans- 
actions can  be  obtained  readily.  We  shall  also  see  in  Chapters  VI 
and  VII  that  we  need  other  figures  for  our  statement  of  operations, 
for  increase  or  decrease  in  proprietorship  from  gain  or  loss  must  be 
analyzedjnto  causes.  Doubly  necessary  is  it,  therefore,  to  have  a 
device  for  making,  as  we  go  along,  records  that  can  be  summarized 
readily  for  our  periodic  statements.  Many  forms  of  books  and 
loose  sheets  are  in  use  for  this  purpose,  but  all  hinge  on  the  use  of 
"debit"  and  "credit,"  and  therefore  we  should  examine  the  signifi- 
cance of  these  terms  before  we  examine  the  books  that  use  them. 
What  Changes  Need  to  be  Recorded.  We  may  well  first  note  that 
what  we  are  after  is  a  device  for  accimiulating  in  a  record,  ready  for 
instant  use,  all 

(i)  increases  in  asset  accounts 

(2)  decreases  in  asset  accoimts 

(3)  increases  in  ownership-claim  accounts 

(4)  decreases  in  ownership-claim  accounts 


22  THE  FUNDAMENTALS  OF  ACCOUNTING 

No  other  changes  are  possible,  of  course,  for  no  others  can  affect  a 
balance  sheet;  and  a  balance  sheet  can  always  express  the  status  of 
a  business.  If  we  were  to  give  a  short  name,  for  convenience,  to 
each  of  these  four  changes,  four  terms  would  seem  to  be  necessary. 
Yet  when  we  realize  that  assets  and  ownership-claims  can  never  get 
confused  with  each  other  if  proper  (distinctive)  titles  are  used  for 
the  accounts  representing  them,  it  appears  that  not  four  names  are 
necessary  for  distinguishing  these  changes,  but,  for  reasons  now  to 
be  indicated,  only  two. 

Explanations  of  Increases  in  Assets.  The  task  of  the  bookkeeper 
is  to  show  the  relations  of  the  business  with  its  owners  and  with 
others  having  ownership-claims,  and  to  show  what  property  the 
business  has  accountability  for.  Every  change  needs  explanation 
from  both  of  these  aspects.  In  a  sense,  every  change  in  any  balance- 
sheet  item  is  made  in  order  to  explain  a  change  in  some  other  item. 
If  we  buy  goods  on  account,  the  increase  in  merchandise  on  the 
balance  sheet  is  explained  by  the  increase  in  accounts  payable,  and 
the  increase  in  accounts  payable  is  explained  by  the  increase  in 
merchandise.  The  two  changes  explain  each  other,  and  each  is  the 
complement  of  the  other.  If,  on  the  other  hand,  we  had  bought  the 
merchandise  for  cash,  the  decrease  in  cash  would  have  been  just  as 
good  an  explanation  of  the  increase  in  merchandise  as  was  the  in*- 
crease  in  accounts  payable  in  the  other  case.  If  we  wish  names  by 
which  to  designate  kinds  of  bookkeeping  records,  "entries"  as  they 
are  called,  we  may  have  the  same  name  for  a  decrease  of  assets  that 
we  have  for  an  increase  of  ownership-claims,  for  they  serve  the 
same  purpose  —  as,  in  the  case  above,  the  decrease  in  cash  and  the 
increase  in  accounts  payable  equally  explaining  an  increase  in 
merchandise. 

Explanations  of  Reductions  in  Ownership-Claims.  Similarly,  if 
the  proprietor  withdraws  cash  for  his  personal  use,  his  ownership- 
claim  is  thereby  reduced,  and  the  decrease  in  cash  is  the  explana- 
tion of  his  reduced  ownership;  but  equally  the  reduction  of  his 
ownership-claim  is  the  explanation  of  the  reduction  in  cash.  Each 
is  the  complement  of  the  other,  and  neither  can  stand  alone,  for 
neither  can  explain  itself.  If,  on  the  other  hand,  instead  of  drawing 
cash  he  had  purchased  goods  for  his  own  use  from  a  firm  of  whom 
his  business  buys,  and  had  had  the  goods  included  in  a  bill  charged 


FUNDAMENTAL  PRINCIPLE  OF  DEBIT  AND  CREDIT     2$ 

to  his  business  and  to  be  paid  by  the  business,  the  increase  in  ac- 
counts payable  (for  the  goods  taken  by  him)  would  explain  the  de- 
crease in  his  ownership-claim  (just  as  if  he  had  withdrawn  cash), 
and  the  decrease  in  his  ownership-claim  would  explain  the  increase 
in  the  other  ownership-claim  (accounts  payable). 

Similarity  of  Different  Types  of  Entry.  So  for  purposes  of  eoc^ 
planation  of  increase  of  assets,  a  decrease  of  another  asset  is  as  good 
as  an  increase  of  ownership-claims;  for  explanation  of  a  decrease  of 
assets,  an  increase  of  other  assets  is  as  good  as  a  decrease  of  owner- 
ship-claims; for  explanation  of  increase  of  ownership-claims,  a  de- 
crease of  other  ownership-claims  is  as  good  as  an  increase  of  assets; 
and  for  explanation  of  decrease  of  ownership-claims,  an  increase  of 
other  ownership-claims  is  as  good  as  a  decrease  of  assets.  There- 
fore the  same  name  may  be  given  to  a  bookkeeping  record  which 
shows  increase  of  assets  as  to  one  that  shows  decrease  of  ownership- 
claims,  and  the  same  name  to  one  which  shows  decrease  of  assets  as 
to  one  that  shows  increase  of  ownership-claims. 

Debit  and  Credit.  The  two  terms  actually  in  use  to  designate 
changes  in  assets  and  in  ownership-claims  are  "  debit "  and  ^^  credit." 
Just  what  these  terms  mean  is  not  important  at  this  moment  — 
indeed  it  is  so  little  important  that  some  who  seem  to  go  no  farther 
say  that  the  terms  mean  nothing  at  all.  As  a  matter  of  fact,  the  use 
of  them  is  much  simplified  by  knowing  and  realizing  what  they 
mean,  and  we  shall  observe  that  soon.  Their  application  can  be 
briefly  tabulated  as  follows: 

A  record  showing  an  increase  of  an  asset  or  a  decrease  of  an  owner- 
ship-claim is  a  debit 

A  record  showing  a  decrease  of  an  asset  or  an  increase  of  an  owner- 
ship-claim is  a  credit 

It  may  seem  as  if  from  this  grouping  of  transactions  gains  and  losses 
have  been  omitted,  but  it  will  be  remembered  that  gains  are  in- 
creases in  ownership-claims,  and  losses  are  decreases  in  ownership)- 
claims,  and  hence  all  classes  of  transactions  are  covered  by  the 
items  listed  above. 

Abbreviations  for  Debit  and  Credit.  Both  "  debit "  and  "  credit  '* 
are  commonly  abbreviated  —  though  just  as  some  deny  that  the 
terms  have  any  meaning,  so  some  deny  that  the  abbreviations  have 
anything  to  do  with  these  terms.    The  abbreviation  "Dr."  doubt- 


24  THE  FUNDAMENTALS  OF  ACCOUNTING 

less  technically  stands  for  "debtor,"  but  it  is  conveniently  used 
also  to  indicate  that  the  record  with  which  it  is  connected  is  a 
"debit"  record,  showing  what  has  been  listed  above  as  a  debit 
change.  Similarly,  the  abbreviation  "Cr."  doubtless  means 
"creditor,"  but  it  is  conveniently  used  for  any  credit  record,  show- 
ing a  credit  change. 

Meaning  of  Credit.  The  classification  of  records,  or  "entries" 
to  specific  accounts,  as  debit  and  credit  may  seem  purely  arbitrary, 
but  it  is  closely  related  to  the  Latin  words  from  which  our  book- 
keeping records  come,  and  to  the  common  words  "credit,"  and 
"debtor"  and  "creditor,"  of  common  speech.  As  a  help  in  re- 
membering which  word  applies  to  which  change,  one  should  re- 
member that  "credit"  in  Latin  means  "he  grants,  he  entrusts." 
From  this  one  fact  and  the  additional  fact  that  "debit"  is  the  op- 
posite of  "credit,"  the  application  of  the  two  terms  to  all  possible 
cases  is  obvious  when  once  observed.  A  further  assistance  may  be 
found  in  the  realization  that  we  speak  in  everyday  language  of 
giving  a  man  credit  for  doing  any  creditable  thing.  That  is  just 
what  we  do  in  bookkeeping  —  give  "credit"  for  a  thing  which 
confers  a  benefit  upon  the  business.  We  credit  the  proprietor  for 
what  he  invests,  because  the  capital  enables  the  business  to  conduct 
operations.  We  for  the  same  reason  credit  a  seller  of  goods  who 
furnishes  us  our  stock  in  trade. 

General  Scheme.  With  this  fundamental  notion  of  credit  and 
realization  that  debit  is  the  opposite  of  credit,  let  us  work  out  a 
general  scheme  of  debit  and  credit  and  a  convenient  way  of  re- 
membering the  distinction  between  debit  and  credit. 

The  whole  system  may  be  based  on  the  fact  that  we  credit  the 
proprietor  for  conferring  upon  the  business  the  amount  of  his 
investment  (increase  of  ownership-claim). 

Every  other  change  in  assets  or  ownership-claims  is  either  similar 
to  that  above  or  is  the  opposite  or  complement  of  it. 

If  the  change  is  similar  to  it,  the  record  is,  of  course,  a  credit 
entry. 

Only  two  types  of  change  are  similar  to  it:  the  first  is  the  increase  of 
proprietorship-claim  through  profits,  and  hence  that  increase 
is  credited  to  ownership-claim;  the  second  is  the  conferring  on 
the  business  (by  any  one)  of  an  asset  otherwise  than  by  invest- 
ment or  profit,  as  by  loan,  thus  increasing  and  crediting  owner- 
ship-claim. 


FUNDAMENTAL  PRINCIPLE  OF  DEBIT  AND  CREDIT     2$ 

All  other  changes  are  opposite  to,  or  complementary  to,  our  basic 
credit,  as 
a  reduction  in  proprietorship-claim  is  the  opposite  change 
in  the  same  account;  and  the  entry  is  a  debit  (opposite 
of  credit) 
an  increase  in  an  asset  is  the  complement  portion  of  the  rec- 
ord of  an  increase  of  ownership-claim;  and  the  entry  is 
a  debit  (opposite  of  credit) 
a  decrease  in  an  asset  is  the  opposite  of  an  increase  in  an 
asset;  and  as  the  increase  gives  a  debit  entry,  the  de- 
crease must  give  a  credit  entry:  this  change  is  doubly 
the  opposite  of  an  increase  of  an  ownership-claim  — 
for  it  is  the  reverse  change,  a  decrease,  in  a  reverse  ac- 
count, an  asset,  and  so  the  entry  is  itself  a  credit. 
In  summary,  then,  we 

credit  for 

ownership-claim  accounts  increases 

asset  accounts  decreases 

debit  for 

ownership-claim  accounts  decreases 

asset  accounts  increases 

For  every  debit  an  equal  amount  must  be  credited  to  some  ac- 
count, else  the  debit  will  not  be  explained;  and  for  every  credit  an 
equal  amount  must  be  debited,  else  the  credit  will  not  be  explained. 
So  debits  must  equal  credits  always. 

Forms  of  Accounts.  We  must  next  observe  the  form  of  accounts. 
The  following  gives  correct  results  but  fails  to  show  the  total  vol- 
ume of  transactions  for  the  year,  and  this  volume  is  often  so  im- 
portant for  guidance  that  it  is  desired  for  the  operating  statement. 
In  each  case  in  the  illustration  below  the  notation  at  the  side 
of  the  amount  shows  what  other  account  was  affected  by  the  trans- 
action which  caused  the  change. 

Cash 

Balance  i,5oo 

Merchandise  200 

Balance  1,300 

Proprietor  400 

Balance  1,700 

Notes  Payable  600 

2,300 

Because  this  form  fails  to  show  the  volume  of  transactions, 
a  form  in  parallel  columns  is^  universally  used,  and  of  these 


26  THE  FUNDAMENTALS  OB'  ACCOUNTING 

columns  the  left  is  used  for  debits  to  the  account  and  the  right 
for  credits,  thus: 

Cash 

{Dr)  {Cr) 

Balance  1,500        Mdse.  200 

Proprietor  400 

Notes  Payable  600 

Now  the  total  of  each  column  is  the  volume  of  that  kind  of  trans- 
action for  the  period  to  date  (including  balances  from  the  preced- 
ing period),  and  the  difference  between  the  two  columns  of  each 
account  is  the  present  balance,  or  indication  of  status,  as  desired 
for  the  balance  sheet.  This  balance  can  be  shown  at  desired  times, 
by  a  device  to  be  described  later,  as  clearly  by  this  parallel-column 
form  as  by  the  single-column  form.  The  book  in  which  this  form  is 
kept  is  called  the  "ledger/'  Let  us  see  how  debits  and  credits  are 
applied  to  this  form. 

Acquisition  of  Asset.  It  is  easy  to  remember,  for  the  reason 
given  on  pages  24-25,  that  an  ownership-claim  account  is  credited 
for  the  conferring  of  an  asset,  and  that  an  asset  account  is  debited 
for  the  asset  conferred.  So  the  figure  for  each  asset  stands  on  the 
left  or  debit  side  of  the  ledger  account  representing  it,  and  additions 
to  the  asset  are  recorded  by  additional  items  on  the  same  side  of  the 
account. 

Surrender  of  Asset.  A  decrease  in  an  asset  is  a  subtraction  from 
it,  and  since  all  asset  accounts  are  debited  when  assets  are  acquired, 
the  bookkeeping  device  for  recording  a  reduction  is  merely  to  credit 
the  asset  account  by  entering  the  item  on  the  right  or  credit  side  of 
the  ledger,  showing  that  the  amount  is  to  be  deducted  from  the 
other  side  when  the  balance  or  present  status  of  the  account  is  to  be 
learned. 

Changes  afifecting  Ownership-Claims.  A  decrease  in  an  owner- 
ship claim  is  a  subtraction  from  it,  and  since  all  ownership-claim 
accounts  are  credited  when  claims  are  created,  the  bookkeeping 
device  for  subtracting  from  an  ownership-claim  account  is  to  debit 
it  for  the  amount  of  the  decrease  in  the  claim;  so,  as  the  original 
claim  was  entered  on  the  right  side  of  the  ledger,  the  reduction  will 
be  entered  on  the  left. 

Summary.    Assets  in  the  possession  of  the  business  are  recorded 


FUNDAMENTAL  PRINCIPLE  OF  DEBIT  AND  CREDIT     27 

on  the  debit  or  left  side  of  the  ledger,  as  are  additions  to  assets;  and 
deductions  are  entered  on  the  credit  or  right  side.  Ownership- 
claims,  and  additions  to  them,  are  credits,  and  deductions  are 
debits.  This  may  be  graphically  expressed  by  the  chart.  It  will 
be  seen  that  credits  are  in 


Anets 


Ownership-CIalsi 


all  cases  opposite  debits, 
and  debits  in  all  cases  are 
opposite  credits.  The  two 
opposites  of  each  pole, 
being  opposite  the  same 
thing,  are  like  each  other; 
and,  as  we  saw  on  page  23, 
they  are  equally  service- 
able for  explaining  that  to 
which  they  are  opposite  —  an  increase  in  an  ownership-claim  is 
as  good  an  explanation  of  an  increase  in  an  asset  as  is  a  decrease 
in  another  asset,  etc.  Each  pair  of  shaded  items  connected  by  an 
arrow  represents  record  of  a  transaction  —  a  debit  and  a  credit  — 
and  the  pairs  of  items  represent,  either  singly  or  in  combination, 
aU  possible  complete  transactions;  for  pairs  not  connected  by 
arrows  cannot  represent  transactions  because  they  comprise  either 
two  debits  or  two  credits,  and  a  complete  record  of  a  transaction 
must  have  equal  debits  and  credits. 

Illustrations.  Let  us  now  try  a  few  illustrations  of  debit  and 
credit,  remembering  that  for  every  dollar  of  debit  made  to  any  ac- 
count a  dollar  of  credit  must  be  made  to  some  account;  for  all 
financial  (bookkeeping)  transactions  must  be  expressed  in  dollars. 
We  may  use  here  the  transactions  that  we  used  for  constructing  the 
balance  sheets  in  Chapter  II,  now  formulating  entries  for  each 
transaction,  transferring  or  posting  them  to  the  ledger,  and  from 
the  ledger  constructing  a  final  balance  sheet.  (The  process  of 
transferring  items  to  the  ledger  is  called  "posting.")  For  the  con- 
venience of  the  reader  in  tracing  entries  into  the  ledger,  the  parts 
of  each  entry  will  be  lettered  and  the  corresponding  items  in  the 
ledger  will  bear  the  same  letters. 

You  and  I  begin  business  as  equal  partners  with  $10,000  in  cash. 
Then  we,  the  proprietors,  have  an  ownership-claim  of  $10,000  to 
the  property  we  have  invested,  and  we  credit  Proprietorship- 


28  THE  FUNDAMENTALS  OF  ACCOUNTING 

Claim  for  that  amount.  The  cash  which  we  have  granted  to  the 
business  is  the  complement  of  the  proprietorship-claim  which  we 
have  credited,  and  therefore  is  debited.  The  entry  expressing  the 
transaction  is: 

Debit  Credit 

I         (a)  Cash  10,000    (b)  Proprietorship-Claim       10,000 

We  now  post  this  to  the  ledger  on  page  30,  lettering  each  item 
in  the  manner  stated  above.  In  actual  practice  a  page  or  definite 
portion  of  a  page  in  the  ledger  is  reserved  for  each  account,  and  all 
postings  to  that  account  must  be  entered  in  that  place.  An  item 
posted  to  the  wrong  space  in  the  ledger  is  worse  than  one  omitted, 
for  it  means  that  two  accounts  are  wrong  —  that  in  which  the  item 
stands  and  that  from  which  it  has  been  omitted;  and,  as  we  shall 
see  later,  the  omission  of  an  item  is  more  likely  to  be  found  than  its 
posting  to  a  wrong  account. 

Now  we  buy  office  furniture  for  $1 ,000  in  cash.  For  the  acquisi- 
tion of  office  furniture  we  debit  Office  Furniture  $1,000,  and  since  in 
acquiring  this  asset  we  have  given  up  another  asset,  cash,  we  credit 
Cash  $1,000.    This  gives  us  the  entry: 

Debit  Credit 

2,  (c)  Office  Furniture       1,000    (d)  Cash  1,000 

We  now  post  this  to  the  ledger. 

Next  we  buy  merchandise  on  account,  $5,000.  We  have  again 
acquired  an  asset,  merchandise.  To  record  this  we  debit  Mer- 
chandise $5,000.  We  have,  however,  incurred  a  liability  through 
this  transaction  —  i.e.,  our  creditor  has  a  claim  against  us  for 
which  we  are  liable  —  and  therefore  to  record  the  claim  we  credif 
Accounts  Payable  $5,000.    The  entry  for  this  is: 

Debit  Credit 

3.  (e)  Merchandise  5,000    (f)  Accounts  Payable  5,000 

This  is  posted  to  the  ledger. 

Now  we  give  promissory  notes  for  $2,000  to  some  of  our  creditors 
as  a  way  of  acknowledging  formally,  through  negotiable  instru- 
ments, our  debt.  We  have  exchanged  one  type  of  ownership- 
claim  for  another.  Notes  Payable  for  Accounts  Payable.  So  we 
credit  the  increased  claim  (Notes  Payable)  and  debit  the  decreased 
claim  (Accounts  Payable)  in  the  following  entry: 


FUNDAMENTAL  PRINCIPLE  OF  DEBIT  AND  CREDIT     29 

Debit  Credit 

4.        (g)  Accounts  Payable    2,ocx3    (h)  Notes  Payable  2,00c 

This  in  turn  is  posted. 

We  now  sell,  for  $4,000  in  cash,  merchandise  which  cost  $3,000. 
We  have  acquired  $4,000  of  cash  through  the  sale  and  so  must  debit 
Cash  $4,000,  but  we  have  given  up  $3,000  of  merchandise  and  hence 
must  credit  Merchandise  $3,000.  It  is  obvious,  however,  that  we 
have  made  on  the  sale  a  profit  of  $1,000,  which  cannot  remain  un- 
claimed, and  since  the  profit  was  made  through  our  enterprise  we 
may  credit  Proprietors'  Profit-Claim  to  record  the  gain.  Our  entry  is : 

Debit  Credits 

$.        (i)  Cash  4,000    (j)  Merchandise  3,000 

(k)  Proprietors' Profit-Claim  1,000 
This  is  now  posted. 

Now  we  use  $2,000  of  our  cash  to  pay  off  our  notes  payable. 
So  we  credit  Cash  $2,000  for  the  reduction  of  asset,  and  debit  Notes 
Payable  $2,000  for  the  reduction  of  ownership-claim.  The  entry 
for  the  payment  is: 

Debit  Credit 

6.  G)  Notes  Payable         2,000    (m)  Cash  3,000 

This  is  posted  to  the  ledger. 

Next  a  change  of  style  in  merchandise  forces  us  to  sell  our  re- 
maining merchandise  (shown  in  the  merchandise  account  as  now 
$2,000)  for  $500  in  cash.  Cash  is  debited  for  the  increase  of  $500. 
Merchandise,  on  the  other  hand,  is  credited  for  a  reduction  of 
$2,000.  So  our  credits  exceed  our  debits.  What  has  happened? 
Inasmuch  as  merchandise  has  been  sold  at  a  loss,  there  is  now  les? 
property  in  the  business  than  is  claimed,  and  claims  must  be  re 
duced  on  the  books.  Outsiders  cannot  be  held  responsible  for 
losses  due  to  our  inability  to  foresee  changes  in  style,  and  conse- 
quently we  must  reduce  our  proprietors'  claim.  The  loss  has  de- 
stroyed not  only  the  $1,000  profit  made  on  previous  sales,  but  in 
addition  $500  of  our  original  investment.    The  entry  for  the  sale  is: 

Debits  Credit 

7.  (n)  Cash  500    (q)  Merchandise  2,000 
(o)  Proprietors'  Profit-Claim    1,000- 

(p)  Proprietorship- Claim  500 

This  entry  is  now  postedto  the  ledger. 


30  THE  FUNDAMENTALS  OF  ACCOUNTING 

Lastly  you  withdraw  from  the  business,  taking  in  cash  your 
share,  but  I  continue  alone.  One-half  of  the  proprietorship-claim 
(your  share)  is  $4,750,  and  this  amount  is  paid  to  you  in  cash. 
Therefore  Cash  is  credited  $4,750,  and  Proprietorship-Claim  is 
debited  for  that  amount.    The  entry  is: 

DehU  Credit 

8.  (r)  Proprietorship-Claim    4,750      (s)  Cash  4,750 

This  is  posted  to  the  ledger. 

The  ledger  which  contains  these  postings  looks  as  we  find  it  be- 
low. It  has  the  same  debit  and  credit  items  as  were  given  above, 
but  the  arrangement  is  classified  rather  than  chronological. 

LEDGER* 

Cash 

(a)  [Proprietorship-Claim]         10,000      (d)  [Office  Furniture]  1,000 

(i)  [Sundries]  4,000    (m)  [Notes  Payable]  2,000 

(n)  [Merchandise]  500      (s)  [Proprietor]  4,75© 

Proprietorship-Claim 
(p)  [Merchandise]  500     (b)  [Cash]  10,000 

(r)  [Cash]  4,75° 

Office  Furniture 
(c)  [Cash]  1,000 

Merchandise 
(e)  [Accounts  Payable]  5,000       0)  [Cash]  3,000 

(q)  [Sundries]  2,000 

Accounts  Payable 
(g)  [Notes  Payable]  2,000     (f)    [Merchandise]  5,000 

Notes  Payable 
G)  [Cash]  2,000      (h)  [Accts.  Payable]  2,000 

Proprietors*  Profit-Claim 
(0)  [Merchandise]  1,000      (k)  [Cash]  1,000 

I  now  wish  to  see  a  balance  sheet  reflecting  the  present  status  of 
the  business.  Listing  the  debit  and  credit  balances  on  the  ledger 
gives  me  what  I  wish,  as  follows: 

^  The  name  of  an  account  in  brackets  [  ]  indicates  the  account  to  which  the 
other  half  of  the  entry  is  posted.  Where  a  change  in  one  account  is  explained  by 
changes  in  more  than  one  other  account,  the  other  accounts  are  not  necessarily 
individually  named,  but  are  indicated  as  a  group  by  the  word  "Sundries." 


FUNDAMENTAL  PRINCIPLE  OF  DEBIT  AND  CREDIT      3 1 

Balance  Sheet 
Cash  $6,750    Proprietorship  $4,75o 

Office  Furniture  1,000    Accounts  Payable  3,000 

$7,750  $7,750 

This  corresponds  exactly  to  the  final  balance  sheet  on  page  16, 
for  it  has  resulted  from  the  same  transactions. 

It  is  obvious  that  making  entries  and  posting  the  items  to  ledger 
accounts  from  which  balance  sheets  may  be  at  any  time  drawn  up 
is  much  easier  and  simpler  than  constructing  perpetually  changing 
balance  sheets  as  shown  in  Chapter  11. 

Note.  No  attempt  is  made  in  the  early  chapters  of  this  book  to  use 
for  titles  of  accounts  the  exact  forms  common  in  business.  The  com- 
mon business  forms  are  more  or  less  abbreviated,  and  the  reader  may 
be  confused  by  them.  The  titles  used  here  are  meant  to  be  more  sug- 
gestive of  the  content  of  the  accounts  than  those  commonly  used. 

QUESTIONS  AND  PROBLEMS 

1.  State  what  transactions  would  give  rise  to  each  of  the  following  entries: 

(i)  A  debit  to  Cash  and  a  credit  to  Accounts  Receivable 

(2)  A  debit  to  Proprietorship  and  a  credit  to  Cash 

(3)  A  debit  to  Notes  Receivable  and  a  credit  to  Accounts  Receivable 

(4)  A  debit  to  Fixtures  and  a  credit  to  Proprietorship 

(5)  A  debit  to  Proprietor's  Profit-Claim  and  a  credit  to  Merchandise 

(6)  A  debit  to  Merchandise  and  a  credit  to  Accounts  Payable 

2.  What  financial  status  is  reflected  by  each  of  the  following  ledger  ac- 
counts? 

Cash 
10,500  10,000 

Accounts  Receivable 
10,000  9,500 

Merchandise 
10,000 

Proprietor 
500  10,000 

Notes  Payable 
1,000  2,000 

Real  Estate 

10,000  $00 


32  THE  FUNDAMENTALS  OF  ACCOUNTING 

3.  Determine  for  the  following  transactions  whether  the  account  named 
in  parenthesis  is  to  be  debited  or  credited. 

(i)  Receiving  cash  for  a  debt  due  you  (Cash),  $500 

(2)  Selling  merchandise  (Merchandise),  $1,000 

(3)  Paying  John  Jones  $3,000  owed  him  Qohn  Jones) 

(4)  Bujdng  merchandise  on  account  (Merchandise),  $2,000 

(5)  Buying  equipment  for  cash  (Equipment),  $500 

(6)  Buying  postage  stamps  (Postage),  $50 

(7)  Paying  for  merchandise  (Cash),  $1,000 

(8)  Receiving  cash  on  accounts  due  (Accounts  Receivable),  $1,000 

(9)  Buying  merchandise  on  account  (Accounts  Payable),  $5,000 
(Cue:  the  debits  called  for  amount  to  $6,050,  the  credits,  to  $8,000) 

4.  Show  what  is  to  be  debited  and  what  credited  for  each  of  the  following 
transactions: 

(i)  A  invests  cash,  $10,000 

(2)  Merchandise  is  bought  on  account,  $3,000 

(3)  Fixtures  are  bought  for  cash,  $1,000 

(4)  Merchandise  which  cost  $1,200  is  sold  for  $1,500  cash 

(5)  Merchandise  is  bought  for  cash,  $4,000 

(6)  Merchandise  previously  purchased  is  now  paid  for,  $3,000 
Do  your  debits  equal  your  credits? 

$.  From  the  entries  made  for  Question  4  construct  the  ledger.  Does  the 
total  of  all  debit  ledger  postings  agree  with  the  total  of  the  debits  in 
Question  4?  Do  the  credit  ledger  postings  agree  with  the  credits  of 
Question  4? 
6.  Construct  debits  and  credits  expressing  the  transactions  given  below 
and  post  them  to  the  ledger. 

(i)  The  proprietor  invests  $20,000  —  $10,000  in  cash  and  $10,000  in 
real  estate 

(2)  Merchandise  is  bought  for  $9,000  on  account 

(3)  Office  equipment  is  bought  for  $850  in  cash 

(4)  Merchandise  which  cost  $1,800  is  sold  for  $1,200  on  account,  and 
for  $800  in  cash 

(s)  Payment  is  made  for  merchandise  previously  bought,  $2,000 

(6)  Insurance  is  prepaid,  $78 

(7)  Merchandise  which  cost  $1,500  is  sold  on  account  for  $1,450 

(8)  The  proprietor  withdraws  $500  in  cash 

(9)  A  promissory  note  is  given  in  payment  of  merchandise  previously 
bought  on  account,  $2,500 

(10)  Merchandise  costing  $5,000  is  sold  for  $5,800  in  cash 

(11)  Payment  of  $2,000  is  made  for  merchandise  previously  bought 
List  the  debit  and  credit  ledger  totals  at  this  point. 


CHAPTER  IV 

THE  INTERPRETATION  OF  DEBIT  AND  CREDIT 

Natxire  of  Debit  and  Credit.  The  illustrations  that  have  been 
used  in  Chapter  III  have  been  of  a  simple  type,  for  all  assets  cov- 
ered by  them  are  tangible  and  easily  recognized  as  assets.  It  is 
now  worth  while  to  take  a  few  cases  less  obvious  and  see  what  we 
can  discover  about  the  nature  of  debit  and  credit.  Let  us  first 
summarize  our  discussion  of  debit  and  credit  to  this  point.  We 
have  seen  that  we  have  on  the  balance  sheet  only  two  main  classes 
of  accounts  —  assets,  and  ownership-claims  (the  latter  embracing 
both  the  controlling-ownership  claims  of  the  proprietor  to  the 
property  of  the  business  [his  investment,  plus  profit,  minus  loss] 
and  the  non-controlling-ownership  claims  of  outsiders).  Since  we 
have  also  seen  that  for  every  dollar  of  debit  there  must  be  a  dol- 
lar of  credit  (else  things  are  not  explained),  it  is  obvious  that  for 
every  dollar  of  debit  to  any  asset  account  there  must  be  a  dollar  of 
credit  either  to  some  other  asset  account  or  to  some  ownership- 
claim  account  (for  there  are  no  other  kinds  of  credits) ;  for  every 
dollar  of  credit  to  any  asset  account,  there  must  be  a  dollar  of  debit 
either  to  some  other  asset  accoimt  or  to  some  ownership-claim  ac- 
coimt;  for  every  dollar  of  debit  to  any  ownership-claim  accoimt, 
there  must  be  a  dollar  of  credit  either  to  some  other  ownership- 
claim  account  or  to  some  asset  account;  and  for  every  dollar  of 
credit  to  any  ownership-claim  account,  there  must  be  a  dollar  of 
debit  either  to  some  other  ownership-claim  account  or  to  some  asset 
account.    The  following  diagram  expresses  this  in  summary  fashion : 


Ownership-ClMm 


This  diagram  is  a  development  of  the  diagram  on  page  27.    Each 
pair  of  shaded  items  connected  by  arrows  represents  an  entry 


34  THE  FUNDAMENTALS  OF  ACCOUNTING 

of  the  type  indicated,  and  all  possible  entries  are  of  one  of  these 
types.  Though  all  this  is  mathematically  and  logically  true,  it  is 
not  always  obvious  in  the  concrete  cases  of  business,  and  there- 
fore we  must  examine  a  number  of  typical  transactions  and  see 
just  the  significance  of  these  principles. 

Examination  of  Debits.  Let  us  examine  first  the  debits  which 
are  made  when  assets  are  given  up  —  that  is,  let  us  take  a  number 
of  cases  in  which  an  asset  account  is  credited  and  see  just  in  what 
senses  it  is  true  that  the  complementary  debit  represents  either 
another  asset  acquired  or  an  ownership-claim  reduced. 

Wages.  If  we  pay  wages  in  a  factory,  we  are  getting  value 
added  to  the  raw  material  of  our  production,  and  hence  are  getting 
back  in  the  form  of  finished  goods  (or  in  goods-in-process,  not  yet 
finished)  what  we  pay  in  wages.  We  are  merely  exchanging  cash 
for  enhancement  of  value  in  goods,  one  asset  for  another.  Finished 
Goods  may  be  debited,  and  Cash  credited.  ^ 

Sales  Salaries.  If  we  pay  a  salary  to  a  salesman,  we  are  again 
getting  a  new  asset  for  an  old.  The  salesman,  if  he  earns  his  salary, 
is  actually  selling  goods  —  he  is  converting  goods  on  the  shelves 
into  goods  sold;  and  goods  in  the  hands  of  a  satisfied  customer  are 
worth  more  than  goods  on  the  shelf.  As  a  matter  of  general  eco- 
nomic principle,  the  skillful  merchant  renders  a  service  to  the  com- 
munity by  adding  to  the  value  of  goods,  for  to  the  valuable  quali- 
ties which  goods  possess  in  the  hands  of  the  manufacturer  he  adds 
the  quality  of  being  where  they  are  wanted  by  the  customer  when 
they  are  wanted  by  the  customer  —  that  is,  in  an  available  store 
ready  to  be  delivered.  The  salesman  contributes  to  that  service 
and  to  the  enhancement  of  value  arising  from  that  service,  and 
hence  he  confers  upon  the  merchant  an  asset  (the  quality  of  being 
in  the  customer's  hands  at  the  right  time)  in  exchange  for  his  sal- 
ary. Sold  Goods  may  be  debited  and  Cash  credited.  (If  the  sales- 
man does  not  earn  his  salary,  the  transaction  is  of  a  different  type, 
to  be  explained  later.) 

*  The  names  of  the  accounts  are  given  here  with  capital  initials;  and  hereafter 
when  an  item  is  given  with  a  capital  initial,  and  otherwise  would  not  have  a  capital, 
it  will  be  understood  to  refer  to  an  account  with  that  title,  whereas  if  the  name  is 
given  with  an  ordinary  small-letter  initial  it  will  be  intended  to  refer  to  the  thing  itseU 
and  not  to  an  account:  thus  "  Cash  "  means  the  account  for  cash,  but " cash  "  meaas 
money;  "Real  Estate"  means  the  account  for  real  estate,  whereas  "real  estate" 
means  the  property  itself. 


THE  INTERPRETATION  OF  DEBIT  AND  CREDIT        35 

Engineer's  Wages.  If  we  pay  wages  to  railroad  engineers,  we 
are  exchanging  cash  for  a  new  asset.  The  new  asset  is  the  move- 
ment of  trains.  Cars  and  locomotives  in  the  storage  yards  are 
earning  nothing;  but  cars  and  locomotives  moving  up  and  down 
the  road  are  worth  more  than  those  standing  idle,  and  this  move- 
ment is  an  asset  secured  by  paying  cash  as  wages  (among  other 
things)  in  exchange  for  it.  Movement  of  Cars  may  be  debited  and 
Cash  credited.  This  is  immediately  followed,  of  course,  or  should 
be,  by  another  conversion  —  movement  of  cars  into  cash  collected. 
When  the  movement  has  so  resulted.  Cash  may  be  debited  and 
Movement  of  Cars  may  be  credited.  If  the  movement  does  not  re- 
sult in  cash  collections  (either  directly  or  through  the  sale  of  tick- 
ets), we  get  another  type  of  transaction  to  be  discussed  later. 

Interest.  If  we  pay  interest  in  advance,  we  exchange  one  asset 
for  another.  Cash  is  given  in  exchange  for  a  right,  and  that  right 
or  claim  consists  of  the  privilege  of  using  other  people's  money  for 
the  purposes  of  business.  Whether  the  money  will  be  used  to  earn 
a  profit  or  merely  to  carry  on  some  desired  enterprise,  such  as  the 
conduct  of  an  educational  institution,  the  privilege  of  using  the 
money  is  an  asset  for  the  purposes  of  the  business  whose  accounts 
we  are  keeping.  We  may  debit  Use  of  Borrowed  Fimds  and  credit 
Cash. 

Insurance.  If  we  pay  fire  insurance  premiums  in  advance,  we 
are  exchanging  cash  for  protection  against  loss  of  property,  and 
since  a  guarantee  of  reimbursement  in  case  of  loss  of  property  is  of 
value,  that  guarantee  is  an  asset.  We  may  debit  Insurance  Pro- 
tection and  credit  Cash. 

^  Taxes.  When  we  pay  taxes  we  get  no  tangible  asset,  but  we  get 
the  right  to  conduct  business  in  the  locality  (which  would  be  denied 
us  by  social  custom  if  we  decHned  to  pay),  we  get  the  protection  of 
police  and  fire  departments,  we  get  the  use  of  roads  and  sidewalks 
and  sewers,  etc.  These  intangible  things  are  assets  quite  as  real  as 
tangible  goods.  Let  any  one  who  denies  it  try  the  experiment  of 
becoming  an  outlaw  and  still  attempting  to  do  business  with 
law-abiding  people.  We  may  debit  Conmiunity  Privileges  and 
credit  Cash. 

Depreciation.  We  have  next  to  consider  certain  transactions  in 
which  the  conversion  of  one  type  of  asset  into  another  is  less  ob- 


36  THE  FUNDAMENTALS  OF  ACCOUNTING 

vious  because  no  direct  cash  is  involved.  Depreciation  of  machin- 
ery is  a  good  illustration.  Here  no  direct  exchange  of  cash  or  any 
other  specific  asset  is  made  for  a  new  asset.  In  reality,  however, 
the  exchange  is  quite  as  real  as  the  exchange  of  cash  for  new  mer- 
chandise: the  only  difference  is  that  the  exchange  is  gradual  rather 
than  immediate.  Suppose  we  spend  $5,000  for  machinery  that  will 
last  ten  years,  but  will  then  be  worn  out  or  behind  the  times  and 
virtually  useless.  Why  do  we  spend  $5,000  for  the  machines  unless 
in  the  expectation  of  getting  back  our  investment,  with  a  profit, 
out  of  the  product  of  the  machine?  The  machines  in  the  process  of 
wearing  out  will  in  the  ten  years  produce  or  become  converted, 
along  with  raw  material  and  labor  and  fuel  consumed  in  creating 
the  steam  to  drive  it,  into  finished  goods,  which  will  be  converted 
into  accounts  receivable,  which  will  become  cash,  which  may  be- 
come new  raw  material  and  new  wages  and  new  machinery  and 
profits.  So  the  wear  and  tear  of  the  machinery  actually  creates 
new  assets.  Depreciation,  therefore,  results  in  the  need  of  an  entry 
debiting  Goods-in-Process  or  Finished  Goods,  and  crediting  Ma- 
chinery —  an  exchange  of  an  old  asset  (in  part  each  year)  for  new. 

Expiration  of  Insurance.  A  similar  thing  is  true  when  we  use  up, 
tlirough  the  lapse  of  time,  such  things  as  fire  insurance  prepaid. 
If  we  debited  Fire  Protection  when  the  insurance  was  paid  for  in 
advance,  we  should  as  time  goes  by  and  the  prepayments  become 
exhausted,  without  waiting  for  their  entire  exhaustion,  debit 
Goods-in-Process,  or  Finished  Goods,  or  whatever  account  repre- 
sents the  assets  which  we  are  getting  from  our  business  activities, 
and  credit  Fire  Protection. 

Partner^s  Salary.  When  we  pay  cash  to  a  member  of  a  partner- 
ship for  his  salary,  as  may  be  called  for  by  the  partnership  agree- 
ment, we  may  be  doing  any  one  of  several  things,  according  to  cir- 
cumstances. If  he  spends  his  time  in  selecting  and  ordering  our 
stock,  we  are  paying  for  a  stock  of  goods  on  hand;  for  a  well-chosen 
stock  is  more  valuable  than  one  of  the  same  initial  value  if  ill-as- 
sorted or  too  large  or  too  small.  If  he  sells  directly  or  superintends 
salesmen  and  directs  their  activities  so  that  they  add  to  the  value 
of  goods  by  getting  them  into  the  hands  of  customers,  we  are  paying 
for  the  increased  value  of  goods  in  the  hands  of  customers;  if  he  is 
the  financial  manager  of  the  business  and  establishes  a  Mne  of  credit 


THE  INTERPRETATION  OF  DEBIT  AND  CREDIT    37 

relations,  we  are  paying  for  the  privilege  of  borrowing  money  at 
perhaps  5%  when  without  his  attention  to  finances  we  might  have 
to  pay  6%.  All  these  things  are  assets  to  the  business.  If  the 
partner  renders  no  personal  service,  but  is  given  a  salary  merely  to 
induce  him  to  allow  the  business  to  use  his  name  or  his  capital,  the 
business  is  giving  cash  in  exchange  for  the  earning  power  of  his 
name  or  his  capital,  and  that  earning  power  is  an  asset.  If,  finally, 
he  is  rendering  no  personal  or  financial  service,  but  draws  a  so- 
called  salary  in  addition  to  interest  on  his  capital,  merely  as  an 
owner  of  the  business,  the  payment  is  then  conferring  no  asset  but 
is  satisfying  his  ownership-claim.  So  in  all  these  cases  the  giving 
up  of  cash  either  acquires  another  asset  or  satisfies  a  proprietor's 
ownership-claim. 

Contribution  to  Charity.  When  we  pay  cash  for  a  charity  fund, 
we  may  be  either  acquiring  an  asset  or  satisfying  an  ownership- 
claim.  If  we  contribute  from  selfish  motives,  in  the  hope  that  the 
reputation  for  generosity  will  increase  our  popularity  or  good  will 
and  bring  trade  (and  if  we  are  right  in  this  hope),  the  asset  is  ex- 
changed for  another  asset;  but  if  we  give  unselfishly,  without  hope 
or  result  in  increased  business,  we  are  disbursing  proprietor's 
ownership-claim  and  thereby  reducing  it. 

PsLjment  without  Return.  In  the  case  of  wages  paid  without 
return  in  the  form  of  goods  sold  (p.  34)  or  fares  collected  (p.  35),  we 
have  another  illustration  of  reduction  of  proprietor's  ownership- 
claim;  but  here  the  reduction  is  not  presumably  voluntary,  but  is 
due  to  one  of  the  mischances  of  business. 

Late  Pajrments.  Our  general  statement  that  debits  show  either 
the  acquisition  of  assets  or  the  reduction  of  ownership-claims  holds 
true  not  only  of  payments  made  in  advance,  but  of  payments  made 
long  after  the  event.  Suppose  we  in  July  pay  wages  earned  in 
May.  We  are  not  apparently  thereby  increasing  our  assets,  for 
the  assets  resulting  from  the  labor  in  May  existed  all  through  June, 
or,  if  they  did  not  so  exist,  they  would  not  be  called  into  existence 
by  payment  in  July.  Let  us  trace  the  transaction  through,  how- 
ever. When  the  work  was  done  in  May,  it  was  presumably  worth 
while  or  we  should  not  have  had  it  done.  If  we  had  kept  our  books 
up  to  the  times,  we  should  have  debited  the  work  done,  perhaps 
^inder  the  name  of  Goods-in-Process,  or  Finished  Goods,  and  we 


38  THE  FUNDAMENTALS  OF  ACCOUNTING 

should  have  credited  some  ownership-claim,  perhaps  employees* 
ownership-claims  —  a  simple  case  of  assets  and  ownership-claimi 
increasing  together.  Then  on  payment  of  wages  in  July,  we  should 
have  debited  Employees*  Ownership-Claims  (wiping  out  that  lia- 
bility) and  credited  Cash.  So  the  disbursement  of  cash,  though 
not  for  another  asset,  would  have  shown  the  reduction  of  an  own- 
ership-claim (assets  and  ownership-claims  decreasing  together). 
Since,  however,  by  supposition,  we  did  not  make  any  entry  in  May 
for  the  work  done  and  for  the  debt  (we  must  under  double-entry 
show  both  if  we  show  either),  we  must  in  July  when  we  pay  show 
the  effect  of  the  transaction  on  both  Goods-in-Process  and  Cash, 
and  make  provision  for  an  entry  to  each.  Our  entry  is  merely  be- 
hind the  times,  and  for  the  sake  of  completeness  of  record  we  should 
catch  up.  Goods-in-Process  must  be  debited  to  show  what  we  got 
for  the  wages  paid,  and  Cash  must  be  credited;  and  it  is  quite  the 
same  thing  whether  the  payment  is  made  at  the  time  the  assets  are 
acquired  or  later,  except  that,  as  we  have  just  seen,  theoretically 
there  is  in  the  meantime  an  ownership-claim  both  set  up  and  paid 
off.  That  ownership-claim  should  be  shown  on  the  books  if  it 
is  unpaid  for  any  appreciable  time;  but  in  practice  it  is  usually 
omitted  altogether  from  the  records  if  standing  but  a  few  days;  so 
that  often  wages  earned  in  one  week  are  not  entered  in  the  accounts 
until  the  next  week  if  paid  in  the  next  week,  and  then  are  treated 
without  mention  of  ownership-claim  at  all,  as  if  the  exchange  were 
Goods-in-Process  directly  and  immediately  for  cash.  So,  in  sum- 
mary, in  case  the  liability  for  the  wages  is  entered  on  the  books,  the 
cash  is  given  up  for  the  cancelling  of  an  ownership-claim;  and  in 
case  the  liability  is  not  so  entered,  the  cash  is  given  up  for  another 
2Lsset:  but  the  net  effect  is  the  same  in  both  cases  —  one  asset  ex- 
changed for  another,  and  the  ownership-claim  cancelled  if  set  up  at 
aU. 

Ex-Post-Facto  Payment.  Now  suppose  it  is  said  that  if  the  work 
done  in  May  went  into  goods-in-process  in  May,  and  no  entry  is 
made  until  July,  at  the  time  the  entry  is  made  in  July  the  asset  will 
no  longer  be  in  the  form  of  goods-in-process,  for  the  goods  may  have 
been  finished  and  sold  and  paid  for.  This  does  not  alter  the  case. 
If  the  goods  have  been  so  converted,  they  have  been  converted  into 
other  assets,  for  the  purpose  of  making  goods-in-process  is  to  con- 


THE  INTERPRETATION  OF  DEBIT  AND  CREDIT        39 

vert  them  into  finished  goods,  and  the  purpose  of  making  finished 
goods  is  to  convert  them  into  accounts  receivable,  and  the  purpose 
of  getting  accounts  receivable  is  to  convert  them  into  cash,  and  the 
purpose  of  getting  cash  is  to  turn  part  of  it  into  new  goods-in- 
process  (to  start  the  cycle  anew)  and  to  give  part  of  it  to  the  pro- 
prietor as  his  gain.  At  whatever  stage  in  the  process  we  stop  or 
however  far  we  go,  as  just  followed  through,  we  find  the  cash  paid 
for  wages  has  become  either  some  other  asset  or  has  paid  an  owner- 
ship-claim, and  the  only  question  is  the  title  of  the  account  to  be 
debited  —  which  will  be  observed  later  for  such  cases.  The  only 
possible  exception  is  that  of  failure  of  the  work  done,  in  payment 
for  the  wages,  to  replace  in  the  form  of  assets  its  cost.  Suppose 
the  work  done  was  not  successful  and  did  not  add  to  the  value 
of  goods-in-process.  No  asset  account  could  be  debited  when 
Cash  is  credited,  for  none  exists  as  a  result  of  the  work.  Some- 
thing must  be  debited  when  Cash  is  credited.  What  has  hap- 
pened? The  proprietor's  money,  or  a  part  of  it,  has  been  paid 
out  for  no  return:  the  proprietor's  assets  have  been  reduced,  and 
hence  his  ownership-claim  has  been  reduced.  So  his  ownership- 
claim  accoimt  must  be  reduced  by  a  debit.  So  here,  too,  when  the 
credit  to  one  asset  account  is  not  accompanied  by  a  debit  to  an- 
other, it  is  accompanied  by  a  debit  to  an  ownership-claim  account. 

Losses  from  Bad  Debts.  Lastly,  for  the  examination  of  debits, 
let  us  suppose  that  a  customer  who  owes  us  $2,000  goes  into  bank- 
ruptcy and  pays  his  creditors  only  fifty  cents  on  the  dollar,  or  $1,000. 
His  account  was  debited  on  our  books  when  he  became  indebted  to 
us,  of  course.  We  must  now  credit  it  for  the  $1,000  paid,  and  this 
leaves  a  balance  impaid of  $ i  ,000  on  the  debit  side.  Since,  however, 
we  cannot  collect  this,  it  is  no  longer  an  asset,  and  it  must  be  can- 
celled, or  "written  off."  The  way  to  cancel  a  debit  is  to  make  an 
offsetting  credit  to  the  same  account.  What  shall  we  debit  when 
we  credit  his  account?  No  other  asset  accoimt  can  be  debited,  for 
no  asset  is  created  or  secured  in  exchange  for  his  cancelled  debt. 
The  cancellation  of  his  debt  simply  reduces  the  assets  of  the  pro- 
prietor, and  hence  reduces  his  ownership-claim.  Hence  the  pro- 
prietors' ownership-claim  account  is  debited. 

Temporary  Uncertainty  Possible.  We  have  so  far  gone  on  the 
assumption  that  we  always  know  whether  the  surrender  of  an  asset 


40  THE  FUNDAMENTALS  OF  ACCOUNTING 

has  acquired  a  new  asset  or  has  merely  depleted  the  proprietors' 
ownership-claim  —  for  example,  whether  the  payment  of  wages 
has  resulted  in  assets  of  at  least  equal  value  or  has  been  in  part  ex- 
travagance because  the  wages  did  not  replace  themselves.  At  the 
time  of  making  an  entry,  however,  we  do  not  commonly  know  the 
result  of  the  transaction;  for  we  cannot  keep  our  investigations  of 
such  things  always  up  to  the  moment.  On  occasion,  however,  and 
always  before  a  periodic  balance  sheet  is  taken  for  determining 
important  matters  of  policy,  such  things  are  investigated  and  the 
appropriate  adjustment  of  the  books  to  the  facts  is  made. 

Summary  of  Debits.  Every  case  we  have  taken,  therefore,  and 
these  are  typical,  shows  us  for  every  decrease  in  an  asset,  and  credit 
to  an  asset  account,  a  complementary  debit  which  represents  either 
another  asset  acquired  or  some  ownership-claim  reduced.  If  the 
complementary  entry  debits  an  asset  account,  the  asset  represented 
by  the  debited  account  is  increased:  if  the  debit  is  to  an  own- 
ership-claim accoimt,  the  claim  represented  by  the  debited  ac- 
count is  reduced.  We  have  now  examined  all  types  of  debits  aris- 
ing from  decreases  in  assets,  i.e.,  all  debits  complementary  to  cred- 
its made  to  asset  accounts.  The  only  other  origin  for  debits  is 
transactions  involving  credits  to  ownership-claim  accounts.  These 
are  simple,  for  we  have  only  four  kinds  of  ownership-claim  credits, 
and  all  these  obviously  involve  either  an  increase  in  assets  or  a  de- 
crease in  ownership-claims.  These  kinds  are  (i)  investment  by 
proprietors  (and  this  of  course  involves  new  assets  or  else  the  in- 
vestment was  not  made),  (2)  profits  belonging  to  proprietors  (anc 
if  the  assets  do  not  exist  the  profits  have  not  been  made),  (3)  bor 
rowing  (and  if  borrowing  was  done,  assets  must  have  been  bor- 
rowed), and  (4)  exchange  of  one  claim  for  another  (or  a  decrease  in 
one  daim  offsetting  a  claim  increased).  In  the  first  three  cases  a 
new  asset  is  involved  in  the  transaction  itself,  and  in  the  last  case 
an  old  ownership-claim  is  reduced  by  the  establishment  of  the  new 
one;  so  that  we  now  find  that  our  general  statement  is  true  for 
debits  arising  from  credits  made  to  ownership-claim  accounts  as 
well  as  for  those  arising  from  credits  made  to  asset  accoimts.  We 
now  have  our  general  principle,  that  debits  always  mean  either  in- 
creases in  assets  or  decreases  in  ownership-claims;  and  since  the 
title  of  an  account  should  indicate  whether  it  represents  assets  or 


THE  INTERPRETATION  OF  DEBIT  AND  CREDIT        41 

ownership-claims,  the  interpretation  of  debits  should  be  easily 
possible. 

Examination  of  Credits.  We  have  already  seen  that  all  credits 
indicate  either  reduction  in  assets  or  increase  in  ownership-claims. 
The  former  are  sufficiently  obvious,  for  they  have  been  amply 
illustrated  in  connection  with  the  debits  to  which  they  are  com- 
plementary. The  latter,  again,  so  far  as  they  consist  of  investment 
by  proprietors  and  loans  by  creditors,  are  obvious.  Certain  other 
types  of  credits,  however,  are  worth  attention  in  this  connection. 

Temporary  Ownership-Claims.  Sometimes  temporary  owner- 
ship-claims are  established  by  the  sale  to  others  of  something  to  be 
consumed  in  the  future.  When  a  railroad  sells  a  mileage  ticket  it 
gets  in  return  cash,  but  the  right  to  rides  represented  by  the  ticket 
will  not  usually  be  completely  exhausted  at  once.  Hence  against 
the  asset  received  (cash)  must  be  set  a  claim  of  the  mileage  holder. 
When  the  ticket  is  sold  the  entry  may  be  a  debit  to  Cash  and  a 
credit  to  Mileage  Holder's  Ownership-Claim.  Then  as  the  mile- 
age is  consumed,  as  evidenced  by  the  conductors'  returns,  Mileage 
Holder's  Ownership-Claim  is  reduced.  Similar  ownership-claims 
are  established  where  tickets  are  sold  in  advance  of  their  use.  Un- 
til an  equivalent  for  the  cash  is  provided,  the  giver  of  the  cash  has  a 
claim  against  the  assets  of  the  business. 

Automatic  Increases  in  Ownership-Claims.  A  business  some- 
times receives  interest  on  money  it  has  loaned  outside  or  has  de- 
posited in  its  bank.  The  interest  is  paid  in  cash  and  the  cash,  of 
course,  must  have  a  claimant.  (If  the  interest  were  not  actually 
paid  the  increase  in  assets  would  be  in  the  form  of  a  claim  for  in- 
terest against  the  person  to  whom  the  money  was  loaned.)  Who 
is  the  claimant  for  the  increase  in  assets?  Obviously  the  owners 
of  the  business.  We  will  therefore  credit  an  account  showing  the 
claim  of  the  owners — thus  increasing  the  Proprietor's  Profit-Claim. 
Sometimes,  too,  a  business  receives  a  commission  for  selling  goods 
for  others.  The  commission  is  presumably  paid  in  cash  (though 
some  other  form  of  asset  would  be  satisfactory),  increasing  the 
general  assets  and  therefore  at  the  same  time  increasing  claims  to 
assets;  for  all  assets  must  have  some  claimant.  Since  the  goods 
were  sold  by  the  business,  the  commission  was  earned  by  it,  and  the 
claim  to  the  profit  made  is  the  proprietor's.    As  in  the  case  of  the 


42  THE  FUNDAMENTALS  OF  ACCOUNTING 

interest  received,  we  may  credit  an  account  indicating  the  nature  of 
the  claim,  or  Proprietor's  Profit-Claim.  If,  again,  we  should  lease  to 
another  business  some  real  estate  which  we  own,  we  should  receive 
rent,  and  the  rent  would  be  paid  in  cash  or  in  some  other  asset. 
The  claim  to  the  asset  would  be  our  ownership-claim.  As  in  the 
case  of  the  interest  and  the  commission,  we  should  credit  Proprie- 
tor's Profit-Claim.  In  all  mercantile  and  manufacturing  busi- 
nesses, of  course,  more  important  than  such  items  as  these  is  the 
profit  on  merchandise,  as  illustrated  in  Chapter  II.  When  such 
profit  is  made,  the  asset  account  representing  the  form  which  the 
profit  has  taken  (Cash,  Accounts  Receivable,  or  Notes  Receivable) 
is  debited,  and  Profit-Claim  is  credited. 

General  Summary.  To  summarize:  a  debit  always  indicates  an 
increase  in  an  asset  or  a  decrease  in  an  ownership-claim;  and  a 
credit  always  indicates  an  increase  in  an  ownership-claim  or  a  de- 
crease in  an  asset;  and,  though  temporarily  imcertainty  may  arise 
as  to  which  has  occurred,  when  time  has  been  given  for  investiga- 
tion of  the  few  doubtful  cases  (such  as  payments  of  wages  for 
which  equal  value  in  return  may  or  may  not  have  been  secured) 
confusion  should  not  result;  for  titles  of  accounts  should  indicate 
clearly  whether  the  figures  gathered  in  them  are  concerned  with 
assets  or  with  ownership-claims.  The  only  way  in  which  confusion 
is  likely  to  occur  is  through  the  carelessness  of  common  speech.  It 
is  common,  for  example,  to  say,  "We  have  received  interest  on  our 
bank  balance,"  though  what  we  have  really  received  is  cash,  in- 
creasing both  assets  and  Proprietor's  Profit-Claim  (subdivision, 
Interest).  Care  must  be  taken  in  bookkeeping  not  to  allow  the 
carelessness  of  common  speech  to  confuse  the  two  changes. 

Note.  The  reader  familiar  with  other  discussions  of  the  theory  of 
accounts  may  be  puzzled  by  the  failure  here  to  mention  what  are  com- 
monly called  "nominal  accounts."  The  whole  treatment  above  is 
based  upon  the  balance  sheet,  as  if  it  were  the  sole  end  of  accounting. 
From  the  point  of  view  of  this  chapter,  it  is  so.  Later,  however,  at- 
tention is  called  to  the  fact  that  statistical  information,  concerning  the 
nature  of  costs  going  into  assets  and  the  nature  of  the  sources  of  income, 
is  necessary  for  guidance  in  the  conduct  of  business,  and  that  separate 
accounts  are  established  representing  the  elements  of  the  assets  and 
of  ownership-claims.  We  shall  see  then,  however,  that  the  so-called 
"nominal  accounts"  actually  represent  assets  or  claims,  and  that  there- 


THE  INTERPRETATION  OF  DEBIT  AND  CREDIT        43 

fore  the  theory  enunciated  here  is  not  only  pedagogically  sound,  in 
avoiding  at  this  stage  the  philosophical  distinction  between  real  and 
nominal  and  mixed  accounts,  but  practically  and  logically  sound  as 
well. 

QUESTIONS  AND  PROBLEMS 

1.  Indicate  to  which  groups  of  accounts  [Asset  Dr.,  Asset  Cr.,  Ownership- 
Claim  Dr.,  Ownership-Claim  Cr.]  entries  for  each  of  the  following 
transactions  should  be  made: 

(a)  Buying  merchandise  for  cash,  $3,215 

(b)  Paying  wages  in  cash,  $873 

(c)  Investing  cash,  $1,000 

(d)  Buying  merchandise  on  credit,  $2,792 

(e)  Paying  accounts  payable,  $5,000 

(f)  Withdrawal  of  $500  by  proprietor 

(g)  Giving  a  note  in  payment  of  an  account  payable,  $1,000 

Test  the  equaUty  of  debits  and  credits.    The  total  debits  are  $14,380. 

2.  The  transactions  following  are  recorded  on  the  books  of  a  business. 
Remembering  that  every  transaction  involves  two  changes,  state 
whether  the  portion  of  each  transaction  indicated  by  italics  below  rep- 
resents a  change  to  be  recorded  in  an  asset  or  in  an  ownership-claim 
account,  and  whether  such  account  is  to  be  debited  or  credited.  Give 
your  reason  for  deciding  as  you  do  in  each  case. 

(a)  Advertising  paid  for 

(b)  Insurance  prepaid 

(c)  Commission  earned  by  us,  but  not  yet  paid 

(d)  Gain  on  sale  of  equipment  owned 

(e)  Rent  earned  on  buildings  owned 

(f)  Depreciation  on  buildings  owned 

(g)  Raw  materials  lost  by  fire 
(h)  Interest  earned  on  bonds 

(i)  Royalties  paid  on  machinery 
(j)  Legal  advice  paid  for 
(k)  Gift  in  cash  to  an  employee 
(1)  Supplies  purchased  on  account 
(m)  Taxes  paid  in  cash 

(n)  The  amount  accrtied  against  us  for  interest  on  money  borrowed, 
when  the  agreement  provides  for  the  payment  of  interest  at  the 
end  of  each  six  months  and  three  months  have  elapsed 

3.  During  the  process  of  manufacture  the  driving  belt  of  a  machine  has 
been  worn  out.  Its  cost  is  still  included  in  the  debit  to  Plant  Equip- 
ment on  the  books.  Assuming  that  the  wear  and  tear  have  not  been 
wasteful,  how  should  you  record  on  the  books  the  exhaustion  of  its 
usefulness? 


CHAPTER  V 

THE  INCOME  SHEET 

Records  Necessary  between  Balance  Sheets.  We  have  already 
seen  that  virtually  every  transaction  brings  about  a  change  on  the 
balance  sheet.  This  suggests  that  the  task  of  providing  informa- 
tion for  a  balance  sheet  that  is  true  to  the  moment  requires  con- 
stant vigilance  and  constant  record.  In  fact,  if  we  were  to  at- 
tempt actually  to  keep  the  balance  sheet  at  all  times  fresh,  we 
should  have  our  hands  more  than  full,  and  the  expense  of  attempt- 
ing it  would  be  far  greater  than  the  value  of  the  information  ob- 
tained. Few  business  houses  attempt  to  learn  exactly  their  profit 
of  tener  than  annually.  This  does  not  mean,  however,  that  they  are 
contented  to  let  things  go  without  any  attempt  to  make  records 
until  the  expiration  of  these  various  periods,  for  there  is  need  of 
watching  at  frequent  intervals  some  of  the  elements  in  the  opera- 
tions of  the  business,  and  therefore  the  records  must  be  kept  up  to 
time  even  though  they  are  not  summarized  and  put  into  the  form 
of  a  definite  statement  except  at  considerable  intervals.  The 
records  indicating  quickly  moving  tangible  property,  like  cash  and 
merchandise,  and  those  indicating  fixed  simis  due  by  and  to  the 
business,  are  usually  kept  day  by  day,  so  that  errors  can  be  de- 
tected, payments  and  collections  can  be  made  promptly,  and  daily 
policy  can  be  determined  intelligently;  but  accruing  items,  which 
are  changing  from  day  to  day  by  mere  lapse  of  time,  like  expiration 
of  insurance  prepaid,  or  growing  liabiUty  for  interest  on  money 
borrowed,  are  usually  allowed  to  run  for  a  convenient  time  with- 
out record,  for  the  policy  of  the  business  need  not  be  frequently 
changed  by  them,  and  are  then  recorded  as  of  a  specified  day  (de- 
termined by  the  circumstances  of  the  case,  as  indicated  later). 

Knowledge  of  Income  not  Enough.  It  is  not  enough,  however, 
for  a  business  man  to  know  whether  his  income  has  increased  or 
decreased  over  a  certain  period,  or  even  day  by  day;  for  that  knowl- 
edge, though  it  may  assist  him  to  know  whether  he  is  getting  richer 
or  poorer,  and  help  him  to  know  whether  he  can  afford  to  spend 
more  or  less  for  his  personal  expenses,  etc.,  does  not  help  him  to 
know  from  what  causes  he  has  got  poorer  or  richer,  and  therefore 


THE  INCOME  SHEET  45 

gives  him  no  means  of  knowing  how  he  may  overcome  the  causes  of 
his  losses  and  make  further  use  of  those  causes  which  bring  him 
gain.  Any  adequate  method  of  record-keeping  will  indicate  for  the 
period  under  consideration  exactly  what  are  the  amounts  of  loss 
from  each  cause  of  loss,  what  are  the  amounts  of  each  kind  of  cost, 
what  are  the  earnings  from  each  ordinary  source  of  gain,  and  what 
are  the  extraordinary  gains. 

Separate  Accounts  to  show  Cause  and  Effect.  As  we  have  seen 
that  we  need  information  about  both  the  origins  of  profits  and  the 
causes  of  losses,  it  is  obvious  that  we  should  not  carry  losses  and 
gains  directly  to  the  proprietor's  account,  though  any  loss  is  a  loss 
to  the  proprietor  and  any  gain  is  his  gain,  but  should  keep  the  vari- 
ous items  of  expenses  and  gain  separate  one  from  another,  as  meas- 
ured in  dollars  and  cents,  in  order  that  they  may  be  watched  care- 
fully for  themselves  and  yet  be  ultimately  shown  in  the  proprietor- 
ship-claim at  the  end  of  such  earning  period  as  has  been  decided 
upon.  In  other  words,  though  there  is  a  proprietorship  account 
with  the  name  of  the  proprietor  indicated  on  the  books,  there  is 
also  a  considerable  group  of  other  accounts  not  showing  the  pro- 
prietor's name  but  indicating  additional  items  of  proprietor's 
ownership  to  be  later  consolidated.  If,  for  illustration,  merchan- 
dise is  sold  for  more  than  it  costs,  the  difference  between  the  cost 
and  the  selUng  price  is  clearly  a  gain,  and  that  gain  has  increased 
the  proprietor's  ownership;  but  it  is  important  also  to  know  that 
the  profit  is  made  on  merchandise,  so  that  one  may  know  how  far  it 
is  profitable  to  engage  in  certain  kinds  of  enterprise;  and  therefore 
some  merchandise  account  should  show  such  profit;  and  the  title 
might  be  ''  Merchandise  Profit  (a  subdivision  of  the  proprietor's 
account)."  Losses  from  bad  debts,  on  the  other  hand,  involve  a 
shrinkage  in  the  proprietorship,  and  therefore  when  a  loss  is 
learned  it  should  reduce  the  proprietor's  account  along  with  the 
reduction  in  the  accounts  receivable;  but  merely  to  do  this  would 
not  show  how  much  of  reduction  either  of  proprietorship  or  of 
accoimts  receivable  was  due  to  losses;  and  therefore  an  account 
is  opened  for  losses  from  bad  debts;  and  this  might  be  entitled 
"Losses  from  Bad  Debts  (a  subdivision  of  the  proprietor's  ac- 
count)." Indeed,  there  may  be  forty  or  fifty  such  accounts,  sub- 
divisions of  the  proprietor's  account,  kept  separately  throughout 


46  THE  FUNDAMENTALS  OF  ACCOUNTING 

an  earning  period  (for  a  month,  a  half  year,  or  a  year)  and  then 
consolidated  into  the  general  account  for  the  proprietor's  profit- 
claim.  This  is  the  usual  method  of  double  entry.  As  a  matter  of 
fact,  however,  the  full  names  indicated  above,  suggesting  subdivi- 
sions of  the  proprietor's  account,  are  never  used,  for  the  custom  of 
business  is  to  recognize  that  such  accounts  are  subdivisions  of  the 
proprietor's  account  without  indicating  that  fact  in  the  titles. 

Complete  Statement  of  Profits  and  Losses.  We  have  already 
observed  that  no  balance  sheet  can  give  any  information  about 
a  business  except  for  a  moment  of  time,  and  the  very  next  hour 
the  situation  will  have  changed.  It  will  have  changed  not  merely 
because  possibly  one  asset  has  been  exchanged  for  another,  or 
because  some  asset  has  been  applied  to  pay  a  debt,  but  usually 
because  there  has  been  some  increase  or  decrease  in  the  proprietor- 
ship. If,  then,  as  we  have  already  seen,  the  proprietor  is  to  be 
given  information  about  the  conduct  of  his  business,  he  must  know 
those  items  which  have  changed  his  proprietorship  not  because  he 
has  invested  more  in  the  business  or  taken  anything  out  (of  which, 
of  course,  he  is  already  aware),  but  because  of  those  business  forces 
causing  gain  or  loss  (of  which  he  may  not  be  constantly  aware), 
and  he  requires  this  information  not  in  isolated  bits,  but  in  a  com- 
plete statement  of  changes  in  proprietorship  involving  both  profit 
and  loss  and  the  net  effect  of  them  all.  He  desires  this  statement  in 
addition  to,  and  clearly  distinguished  from,  the  kind  of  statement 
previously  discussed,  which  gives  the  status  of  the  business  at  any 
definite  moment  of  time.  Here  we  wish  a  statement  of  changes 
over  a  considerable  period  of  time,  resulting  in  the  conditions  shown 
on  the  balance  sheet  at  the  end  of  that  time.  Usually,  too,  such  a 
statement  will  show  what  disposition  of  profits  was  made  —  e.g., 
whether  withdrawn  or  left  in  the  business .  Such  a  statement  is  com- 
monly called  an  "  income  sheet."  The  following  is  an  illustration: 

Profit  on  merchandise  $500 

Commission  earned  400 

Rent  earned  200 

Interest  earned  300 

Gross  income 

Loss  from  bad  debts 

Net  income  $1,200 

Drawn  by  proprietor  200 

Balance  undrawn  $1,000 


THE  INCOME  SHEET  47 

Net  Effect  of  Income  Sheet  Reflected  in  Balance  Sheet.  It 
should  be  noted  again  at  this  point  that  the  balance  sheet  at  any 
time  shows  the  condition  of  the  business  after  the  transactions  in- 
dicated by  the  income  sheet  have  been  incorporated  on  the  books. 
On  the  income  sheet  just  shown  we  find  that  the  gain  has  been 
$1,200,  and  that  the  proprietor  has  drawn  $200.  A  balance  sheet 
taken  at  this  point,  therefore,  will  show,  as  compared  with  that  at 
the  beginning  of  the  period,  an  increase  of  proprietorship-claim  of 
$1,000;  but  though  it  must  show  at  least  one  other  effect,  the  detail 
of  that  effect  will  depend  upon  circumstances.  If  all  other  condi- 
tions except  the  profit  are  the  same  as  at  the  end  of  the  preceding 
period,  and  if  the  profit  is  now  in  the  form  of  cash,  the  balance 
sheet  will  now  appear  (supposing  the  balance  sheet  on  page  8  to 
be  that  of  the  beginning  of  the  period)  as  follows: 

Real  Estate  $50,000  Proprietor  $93,000 

Fixtures  2,000  Accts.  Payable  45,000 

Accts.  Receivable  55>ooo 

Merchandise  25,000 

Cash  6,000 

$138,000  $138,000 

If,  on  the  other  hand,  the  undrawn  profits  had  been  applied,  as  fast 
as  made,  to  paying  debt,  the  balance  sheet  would  now  show  Cash 
only  $5,000,  or  as  it  was  on  our  prior  balance  sheet,  and  Accounts 
Payable  would  show  only  $44,000.  The  profit  here,  then,  would 
lie  in  a  reduction  of  debt  rathej  than  in  an  increase  of  assets.  In 
other  words,  the  income  sheet  does  not  show  us  in  what  form  the 
profit  now  stands,  nor  what  changes  in  the  form  of  assets  and  Ha- 
bilities  have  been  involved  in  earning  these  profits.  It  does,  how- 
ever, show  us  what  change  in  proprietor's  ownership-claim  has 
occurred,  and  from  what  sorts  of  operations,  and  we  thereby  know 
how  much  change  there  must  be  in  either  the  assets  or  the  liabilities 
to  match  the  change  in  proprietor's  ownership-claim;  for  no  one  has 
made  a  profit  at  all  unless  he  has  either  more  assets  or  fewer  liabili- 
ties. Only  a  study  of  both  income  sheet  and  balance  sheet  will  tell 
the  whole  story.  Indeed,  to  teU  the  whole  story,  we  need  two  bal- 
ance sheets  and  an  income  sheet  —  the  two  balance  sheets  give  the 
terminals  of  the  journey  (the  start  and  the  finish),  and  the  income 
sheet  gives  some  of  the  details  of  the  journey  itself. 


48  THE  FUNDAMENTALS  OF  ACCOUNTING 

QUESTIONS  AND  PROBLEMS 

I.  Should  you  expect  to  record  day  by  day  all  information  concerning 
each  of  the  following?    State  why  you  answer  as  you  do  in  each  case. 

(a)  Cash 

(b)  Depreciation 

(c)  Accounts  Payable 

(d)  Interest 

(e)  Accounts  Receivable 

(f)  Insurance  Prepaid 

(g)  Notes  Receivable 

r.  The  following  is  the  balance  sheet  of  A,  B  &  Co.  on  January  i,  1919: 


Real  Estate 

$  5,000 

Proprietor  A 

$11,500 

Cash 

3,000 

Proprietor  B 

11,500 

Merchandise 

14,000 

Accounts  Payable 

3,000 

Accounts  Receivable 

S,ooo 

Notes  Payable 

1,000 

Insurance  Prepaid 

Soo 

Wages  LiabiUty 

500 

$27>5oo  $27,5cx) 

The  income  sheet  on  January  31,  1919,  was  as  follows: 

Profit  on  merchandise  $1,500 

Rent  earned  300 

Interest  earned  200 

Gross  income  $2,000 

Loss  from  bad  debts  200 

Net  income  $1,800 

Drawn  by  proprietors  ($1,000  each)  2,000 

Balance  overdrawn  $200 

If  there  has  been  a  reduction  of  $2,000  in  Accounts  Payable,  and  of 
$1,000  in  both  Merchandise  and  Accounts  Receivable,  but  there  have 
been  no  other  changes  on  the  balance  sheet  except  those  effected  by 
the  profit  and  its  withdrawal  (both  in  cash),  is  the  following  balance 
sheet  for  February  i,  1919,  consistent  with  the  balance  sheet  and  the 
income  sheet  above?  If  so,  explain  all  changes  in  the  second  balance 
sheet  as  compared  with  the  first,  and  if  it  is  not  consistent  show  why  it 
is  not. 


Real  Estate 

$  5,000 

Proprietor  A 

$11,400 

Cash 

2,800 

Proprietor  B 

11,400 

Merchandise 

13,000 

Accounts  Payable 

1,000 

Accounts  Receivable 

4,000 

Notes  Payable 

1,000 

Insurance  Prepaid 

500 

Wages  Liability 

500 

$25,300 

$25,300 

From  the  following  information  given  by  the  ledger  as  of  a  certain  date 
construct  a  balance  sheet  for  that  date  and  an  income  sheet  for  the 
preceding  period:  proprietor  $93,000,  real  estate  $20,000,  notes  pay- 


THE  INCOME  SHEET  49 

able  $3 5, 000,  accounts  payable  $50,000,  rent  earned  $1,500,  accounts 

receivable  $78,000,  interest  earned  $500,  merchandise  $57,000,  profit 

on  merchandise  $10,000,  cash  $25,000,  withdrawals  of  profits  by  the 

proprietor  during  the  preceding  period,  as  profits  have  been  earned, 

$10,000. 

The  balance  sheet  of  a  business  on  January  i,  1919,  was  as  follows: 

Office  Equipment        $  1,000  Proprietor  $40,000 

Accounts  Receivable     37,000  Wages  Liability  500 

Cash  2,500  

$40>5oo  $40,500 

On  January  i,  1920,  the  balance  sheet  was: 

Office  Equipment        $  1,000        Proprietor  $41,000 

Accounts  Receivable     35,000 
Cash  5»ooo 


$41,000  $41,000 

From  the  two  balance  sheets  and  from  the  information  given  below 
construct  the  income  sheet  for  the  year  1919.  Commission  earned 
was  $3,000,  gain  from  services  was  $12,000,  losses  from  bad  debts  were 
$1,000. 
5.  Should  you  need  for  guidance  in  conducting  a  manufacturing  business 
any  general  information  about  its  operations,  expressible  in  dollars 
and  cents,  not  given  on  the  balance  sheet  or  the  income  sheet?  If  so, 
what?  Do  you  see  any  way  of  getting  it  by  bookkeeping  methods?  If 
so,  tell  briefly  by  what  methods. 


CHAPTER  VI 

THE  OPERATING  STATEMENT  —  UNDER 
COST-ACCOUNTING  METHODS 

Klnowledge  of  Specific  Costs  and  Specific  Sources  of  Gain.    We 

have  now  seen  how  by  a  subdivision  of  the  proprietor's  ownership- 
claim  account  we  can  provide  him  with  periodic  information  about 
the  nature  of  the  losses  and  earnings  of  his  business.  This  is  good 
as  far  as  it  goes,  but  it  does  not  go  far.  He  is  likely  to  wish  to 
know,  for  example,  how  the  profit  on  merchandise  was  made  up  — 
how  much  of  it  arose  from  difference  between  buying  price  of  mer- 
chandise and  selling  price,  and  how  much  of  that  difference  was 
absorbed  by  wages  of  salesmen,  by  advertising,  by  taxes,  by  rent,  by 
light,  by  freight  charges,  etc.  In  order  to  do  things  economically, 
he  must  know  when  he  makes  a  saving  and  when  he  has  an  increase 
of  costs,  so  that  he  may  immediately  seek  for  the  source  of  the  sav- 
ing and  duplicate  it,  or  seek  for  the  cause  of  the  increase  in  cost  and 
avoid  it  in  future.  No  better  help  to  successful  conduct  of  business 
is  found  than  knowledge  of  specific  costs  and  specific  sources  of  gain. 
Accounts  for  Specific  Information.  Our  accounts  as  so  far  con- 
structed have  not  given  us  much  information  of  this  sort.  We 
have  shown  the  cost  of  raw  materials,  and  of  the  various  other 
items  going  into  goods-in-process;  but  we  have  not  traced  the 
elements  making  up  the  excess  cost  of  goods-in-process  over  raw 
materials,  or  of  finished  goods  over  goods-in-process,  etc.  Even  if 
we  knew  the  added  costs  to  be  excessive  in  any  step  along  the  way, 
we  should  not  know  from  our  books  where  to  look  to  find  them. 
Obviously  we  must  make  more  careful  record,  as  we  go,  of  the  spe- 
cific costs  that  go  upon  our  raw  material  to  make  up  our  goods-in- 
process,  and  of  those  that  go  upon  our  goods-in-process  to  make  up 
our  finished  goods.  Since  for  ordinary  accounting  purposes  we  put 
things  on  our  books  for  what  they  cost  us  (any  proper  departures 
from  that  rule  will  be  discussed  later),  we  wish  the  cost  of  creating 
assets  to  appear  on  our  books  as  increasing  the  value  of  the  assets, 
as  we  have  already  done  in  the  illustrations  adding  the  cost  of 
manufacturing  wages  to  goods-in-process,  etc.    At  the  same  time, 


THE  OPERATING  STATEMENT  51 

however,  we  see  that  if  we  are  to  watch  our  wages  cost  and  know 
the  effect  of  a  change  in  the  rate  of  wages  upon  our  costs  of  finished 
goods,  we  must  separate  wages  costs  from  other  costs  going  into  our 
goods-in-process.  In  other  words,  instead  of  debiting  Goods-in- 
Process  directly,  as  in  the  illustrative  entries  given,  we  may  debit 
^' Wages  (a  subdivision  of  goods-in-process)";  or,  as  we  have  al- 
ready done  with  profits,  we  may  omit  the  subtitle,  and  call  it  simply 
"Wages";  but  we  must  remember  that  since  the  account  is  only  a 
detail  of  our  addition  to  goods-in-process,  work  done  for  the  wages 
has  increased  the  value  of  goods-in-process.  For  the  purpose  of  the 
illustrations  following,  we  will  assume  that  all  costs  incurred  result 
in  an  increase  in  assets,  for  of  course  the  costs  would  not  be  volun- 
tarily increased  if  that  were  not  the  case  (later  we  will  discuss 
those  things  which  do  not  result  in  increase  of  assets  but  reduce 
proprietor's  ownership-claims). 

Wages  —  A  Typical  Cost  Account  The  case  of  wages  just  given 
is  typical  of  a  large  group  of  costs  entering  into  various  assets,  but 
requiring,  in  order  that  we  may  study  them  and  judge  of  their 
wholesomeness  or  unwholesomeness,  separate  record.  Let  us  ex- 
amine some  other  elements  needing  separate  record. 

Power — Its  Elements.  Every  one  knows  that  power  is  one  of 
the  costs  of  manufacturing  by  power-driven  machinery,  and  that  if 
steam  gives  the  power  and  is  generated  in  one's  own  boilers  fuel  is  a 
cost  of  power.  Besides  fuel,  moreover,  the  cost  of  power  includes 
the  cost  of  lubricating  oil  for  the  engine,  repairs  of  the  engine  and 
boiler,  and  numerous  other  items  not  necessary  to  specify  here. 
The  power  going  through  the  machinery  converts  the  raw  material 
or  partly  finished  product  into  goods-in-process  or  finished  goods 
and  so  increases  the  assets;  but  in  order  to  direct  our  factory  opera- 
tions successfully  we  must  know  more  than  the  total  cost  of  even 
this  small  subdivision  of  cost  of  assets.  We  must  be  able  to  learn 
whether  it  is  better  to  use  electric  power  than  steam,  to  use  fuel  oil 
than  coal,  to  buy  power  than  to  provide  it  ourselves;  and  these 
things  require  that  we  know  the  elements  of  our  power  cost.  We 
ought  to  know,  for  example,  whether  one  kind  of  lubricating  oil 
is  cheaper  for  us  than  another  —  not  merely  per  barrel  but  per 
unit  of  horse-power  produced.  This  means  that  we  must  know 
our  cost  of  oil  as  a  separate  part  of  our  power  cost. 


52 


THE  FUNDAMENTALS  OF  ACCOUNTING 


Raw  Material  $2,000 

Wages               1,500 

Fuel 

$200 

Power                 700  ■ 

OU 
Repairs 

SO 
250 

Other  Costs 

200 

Other  Costs         800 

Elements  of  Goods-in-Process.  Let  us  tabulate  these  items 
already  mentioned,  with  assumed  costs,  realizing  that  they  make 
but  a  small  part  of  the  total  number  of  costs  to  be  watched,  and 
covering  the  others  by  an  item  of  "other  costs." 


Goods-in-Process  $5,000 


Separate  Account  for  Each  Element.  The  best  way  to  record 
these  facts  for  reference  is  in  accounts.  Such  accounts  represent 
the  various  elements  of  the  cost  of  acquiring  assets.  Care  must  be 
taken  not  to  get  any  of  them  on  the  books  and  on  the  balance  sheet 
twice,  for  they  would  be  counted  twice  if  we  should  count  them 
both  as  goods-in-process  and  as  wages  and  power,  or  as  both  power 
and  fuel.  So  they  are  entered  in  the  first  instance  as  raw  material, 
wages,  fuel,  oil,  repairs,  and  as  whatever  other  things  they  chance  to 
be — and  then  protection  is  provided,  as  we  shall  see  later,  against 
counting  them  again  in  the  accounts  for  consolidation  of  elements. 

Assets  Changing  Form.  An  interesting  fact  to  observe  now  is 
that  though  these  kinds  of  costs  are  elements  of  goods-in-process, 
and  are  debited  to  several  accounts  rather  than  to  the  single  account 
representing  such  goods,  some  of  these  accounts  (such  as  wages, 
fuel,  oil,  repairs)  do  not  long  represent  assets  recognizable  under 
the  names  used  in  the  titles  of  the  accounts:  fuel  consumed  is  not 
recognizable  as  an  asset  in  the  form  of  fuel,  for  it  has  ceased  to  be 
fuel  virtually  at  the  moment  it  serves  its  purpose;  oil  consumed 
ceases  to  be  oil;  and  by  consumption  in  the  engine  both  oil  and  fuel 
contribute  to  assets  in  the  form  of  goods-in-process  (on  the  assump- 
tion previously  made  that  production  is  efficient).  Fuel  and  oil 
consumed,  then,  though  they  no  longer  consist  of  fuel  and  oil  as 
such,  constitute  the  fuel  and  oil  elements  in  goods-in-process  and 
hence  constitute  assets  as  much  as  they  ever  did,  but  assets  no 
longer  recognizable  under  the  names  used  in  the  titles  of  their  ac- 
counts. If,  then,  we  were  to  keep  our  books  always  up  to  the  facts 
of  the  minute,  we  should  each  moment  debit  Goods-in-Process  and 


THE  OPERATING  STATEMENT  53 

credit  Fuel  and  Oil  for  the  amounts  of  each  consumed.  The  same 
thing  would  be  done  for  wages,  repairs,  and  a  multitude  of  other 
things  which  lose  their  identity  in  their  original  form  but  go  to 
make  up  other  forms  of  assets;  and  yet  for  many  of  them  this  is 
not  done  but  the  accounts  are  kept  as  if  the  assets  were  in  their 
original  form,  so  that  we  may  have  the  statistical  record  of  their 
existence  without  the  multitudinous  entries  of  recording  minute 
by  minute  and  day  by  day  their  transformations. 

Current  Changes  Recorded.  For  some  items  of  this  sort,  how- 
ever, it  is  desirable  to  make  the  entries  for  transformations  virtually 
day  by  day.  In  a  well  organized  factory,  for  instance,  it  is  common 
to  provide  that  whenever,  and  however  many  times  a  day,  raw 
material  is  sent  from  the  storeroom  to  the  shop  to  be  used  for 
manufacturing,  Goods-in-Process  is  debited  and  Raw  Material  is 
credited.  (The  actual  items  are  not  entered  in  the  ledger  individu- 
ally, but  the  figures  of  each  item  are  found  and  accumulated  for 
entry  in  lump  sum.)  This  is  because  we  wish  to  know  at  all  times 
how  much  material  we  have  on  hand,  and  hence  as  Raw  Material  is 
debited  when  such  material  is  bought,  it  must  be  promptly  credited 
when  taken  out  of  the  storeroom  for  use. 

Current  Changes  not  Recorded.  Usually  the  title  of  the  account 
will  itself  suggest  whether  one  should  expect  to  recognize  the  prop- 
erty under  the  name  used  in  the  title  of  the  account  for  it  or  to  find 
that  it  has  lost  its  identity  by  being  merged  in  something  else.  Of 
this  type,  wages  are  a  good  illustration,  for  wages  as  such  have  no 
identity  —  before  payment  wages  are  not  wages  but  money,  and 
after  payment  they  are  not  in  the  business  at  all:  the  value  given 
for  wages,  however,  is,  in  another  form,  in  the  assets  produced  by 
the  wages,  but  continues  to  be  shown  in  the  account  for  wages. 

Another  Illustration.  Perhaps  the  most  extreme  illustration 
that  can  be  given  of  this  sort  of  cost  is  the  royalty  paid  by  a  shoe- 
manufacturing  firm  to  the  manufacturer  of  the  shoemaking  ma- 
chinery which  it  uses.  The  owners  of  the  patents  on  the  shoe- 
making  machinery  make  the  shoemaking  machines  but  never  sell 
them:  they  lease  machines  to  shoe  manufacturers,  and  keep  them 
in  repair  and  replace  them  when  worn  out.  For  the  use  and  main- 
tenance of  the  machines  the  shoe  manufacturers  pay  a  royalty. 
This  royalty  payment  gives  a  right  to  use  productive  machines. 


54  THE  FUNDAMENTALS  OF  ACCOUNTING 

Though  absolutely  intangible  and  not  representing  the  value  of 
any  specific  property  that  the  shoe  manufacturers  can  call  their 
own,  it  is  nevertheless  a  cost  of  manufactured  goods  and  is  repre- 
sented in  the  goods  manufactured  because  it  has  reproduced  itself 
in  the  goods  (for  these  machines  do  the  work  of  many  hand  labor- 
ers and  therefore  contribute  to  the  goods  what  the  hand  laborers 
would  contribute).  We  might  debit  Goods-in-Process,  or  Finished 
Goods,  and  credit  Cash  for  royalty.  This,  however,  would  not 
show  on  our  books  the  statistical  information  about  royalties  paid, 
and  therefore  it  is  far  better  to  debit  Royalties,  as  a  subdivision  of 
our  Goods-in-Process,  and  credit  Cash.  In  no  way  can  the  royal- 
ties be  identified  in  the  product,  but  they  are  as  truly  there  as  is  the 
leather  which  may  conceivably  be  traced  back  to  a  particular  skin 
bought:  pieces  of  leather  sewed  together  in  a  shoe  are  worth  more 
than  as  leather,  and  the  cost  of  sewing  them  together  is  a  cost  re- 
produced in  the  asset;  hence  in  every  shoe  made  is  a  bit  of  the  roy- 
alty paid,  for  the  royalty  helped  to  convert  the  leather  into  the 
finished  shoe.  The  total  royalties  paid  for  a  period,  then,  consti- 
tute a  part  of  the  cost  of  acquiring  assets  and  are  in  the  assets  in  the 
form  of  shoes.  The  account  for  royalties,  then,  both  represents 
assets  and  gives  us  the  statistical  figure  of  royalty  costs  incurred. 

Other  Illustrations.  Akin  to  the  payment  of  royalties  as  just 
described  are  payments  for  insurance,  taxes,  interest,  rent,  heat, 
light,  etc.,  which  serve  their  ends  in  making  up  the  product  and 
hence  are  elements  of  product;  and  the  records  of  these  are  kept 
for  statistical  purposes,  but  they  are  at  the  same  time  in  reality 
subdivisions  of  Goods-in-Process  or  Finished  Goods,  though  each 
bears  the  name  of  the  kind  of  transaction  involved  —  Insurance, 
Taxes,  Interest,  Rent,  etc. 

Goods-in-Process.  Our  assets  in  the  form  of  product,  as  we 
have  just  been  seeing,  are  first  represented  in  many  separate 
accounts  for  detailed  elements,  and,  as  we  saw  a  few  moments  ago, 
many  of  these  elements  are  consumed  in  their  original  form  almost 
as  soon  as  they  are  acquired  (labor  services,  for  instance).  Theo- 
retically, we  should  daily  debit  Goods-in-Process  and  credit  Insur- 
ance, Taxes,  etc.,  for  the  day's  transformations.  Then  the  debit 
to  the  accounts  representing  the  elements  going  into  our  product 
would  give  us  our  desired  statistics,  and  the  transfer  of  these  to 


THE  OPERATING  STATEMENT  55 

Goods-in-Process  (exchange  transactions)  would  give  us  our  costs 
involved  in  manufacturing.  Some  of  the  entries  involved  in  these 
transformations  we  can  conveniently  make  and  do  make  daily, 
but  for  most  of  them  more  bookkeeping  labor  would  be  required 
than  would  be  worth  while  for  the  information  obtained,  and  hence 
the  entries  are  made  at  intervals  only.  The  goods-in-process,  in 
turn,  soon  become  finished  goods,  and  so  Goods-in-Process  must 
be  credited  and  Finished  Goods  must  be  debited  for  the  cost  of 
all  goods  sent  from  the  shop  to  the  warehouse  as  completed.  The 
balance  of  Goods-in-Process  when  the  books  are  kept  up  to  the 
time  represents  the  cost  of  goods  in  the  shop  uncompleted. 

Finished  Goods.  We  saw  in  the  last  paragraph  that  when 
goods  are  finished  in  the  shop  they  are  transferred  to  the  warehouse 
or  salesroom,  and  an  entry  is  made  debiting  Finished  Goods  and 
crediting  Goods-in-Process  for  the  cost  of  the  goods  transferred. 
This  is  simple  if  the  costs  of  the  goods  are  known  as  they  should  be. 
Finding  the  cost  of  finished  products  day  by  day,  so  that  we  can 
debit  Finished  Goods  and  credit  Goods-in-Process,  is  not  altogether 
simple;  for  we  cannot  usually  identify  the  various  elements  of 
costs  in  the  product  or  without  prohibitive  bookkeeping  labor  dis- 
tribute them  daily  on  a  comprehensive  plan.  Consequently  some 
cost-finding  method  (which  need  not  now  be  described)  is  adopted 
to  give  the  information  necessary  for  debiting  Finished  Goods. 
Finally,  when  finished  goods  are  sold,  Sold  Goods  is  debited  for 
the  cost  of  the  goods  (as  previously  debited  to  Finished  Goods 
and  credited  to  Goods-in-Process),  and  Finished  Goods  is  cred- 
ited. This,  it  will  be  observed,  leaves  Finished  Goods  with  a 
debit  balance  equal  to  the  cost  of  the  goods  finished  and  not  sold 
— the  cost  of  goods  remaining  in  the  warehouse.  After  the  cost 
of  the  goods  has  once  been  obtained,  it  is  carried  along  through 
Finished  Goods  to  the  sale  with  no  bookkeeping  difficulty. 

Sold  Goods.  At  the  same  time  that  Sold  Goods  is  debited  and 
Finished  Goods  is  credited,  another  debit  and  credit  are  made  to 
show  what  was  got  for  the  goods  sold,  as  we  shall  see  presently 
(page  62). 

Summary.  We  find,  then,  that  at  any  particular  moment  the  as- 
sets secured  for  conversion  purposes  may  appear  in  any  of  sev- 
eral accounts  on  the  books:  accounts  representing  original  form, 


56  THE  FUNDAMENTALS  OF  ACCOUNTING 

goods-in-process,  finished  goods,  or  sold  goods.  Many  things  are 
allowed  to  remain  on  the  books  under  their  original  titles  long 
after  they  have  been  consumed  in  their  original  form  as  fuel,  insur- 
ance prepaid,  etc.,  and  then  at  convenient  intervals  they  are  trans- 
ferred on  the  books  to  the  accounts  representing  the  forms  which  they 
have  now  taken.  In  other  words,  for  considerable  periods  certain 
assets  appear  on  the  books  not  under  names  representing  the  pres- 
ent forms  of  those  assets,  but  under  names  representing  old  forms 
already  supplanted  or  consumed  in  acquiring  new  forms.  This  does 
no  harm,  however,  if  it  is  generally  understood  by  all  concerned 
with  the  books  and  records  that  the  titles  no  longer  represent  the 
present  status.  As  a  matter  of  fact,  as  already  indicated,  in  most 
businesses  so  many  transactions  occur  daily  that  it  would  be  a  waste 
of  time  to  attempt  to  show  all  details  daily.  Before  a  balance  sheet 
could  be  drawn  up  on  Tuesday  morning  to  show  the  status  on  Mon- 
day night  it  would  be  already  behind  the  times.  So  balance  sheets 
are  drawn  up  periodically,  and  no  attempt  is  made  to  keep  all  infor- 
mation up  to  the  times  between  the  dates  of  balance  sheets.  In 
the  meantime,  statistical  information  of  extreme  value  is  compiled. 
Precautions.  Only  two  precautions  are  necessary.  The  first  is 
to  see  that  all  titles  to  accounts  are  so  clear  that  one  knows  what  to 
do  with  the  accounts  under  them  at  the  time  the  books  are  brought 
up  to  the  minute  and  the  balance  sheet  is  prepared.  The  second  is 
to  see  that  we  realize  that  some  of  the  costs  incurred  may  not  yet 
have  gone  altogether  into  the  goods  produced.  We  saw  a  few  mo- 
mentsago,  for  example,  that  when  we  buy  raw  material  we  debit 
the  Raw  Material  account  and  credit  Cash  or  Accounts  Payable, 
and  that  when  the  raw  material  is  issued  to  the  shop  to  be  used  we 
debit  Goods-in-Process  and  credit  Raw  Material.  It  would  be 
a  bad  mistake  to  debit  Goods-in-Process  for  all  the  raw  material 
bought  in  any  period  if  much  of  it  were  not  used  until  later  periods. 
The  same  thing  is  true  of  all  our  other  costs.  If  we  pay  rent  in  July 
for  three  months,  we  must  not  deem  that  rent  to  be  a  contribution 
to  the  goods  produced  in  July  only,  but  to  the  goods  of  three 
months.  In  other  words,  we  must  always  analyze  the  situation  and 
see  what  adjustments  or  distributions  are  to  be  made  of  the  things 
which  we  have  given  up  in  exchange  for  new  things.  Not  all  of 
what  is  given  up  is  necessarily  exchanged  for  immediate  return  in 


THE  OPERATING  STATEMENT 


57 


new  things,  but  only  so  much  of  it  as  is  consumed  in  getting  the 
particular  new  things  now  imder  consideration.  So  though  our 
insurance  is  paid  in  July,  possibly  only  one-twelfth  of  that  is 
chargeable  to  the  goods  produced  in  July.  If  we  kept  our  books 
always  up  to  the  times,  we  should  daily  debit  Goods-in-Process  for 
the  expiration  of  insurance  and  credit  the  accoimt  for  prepaid  in- 
surance; but  this  is  so  much  work  that  ordinarily  it  would  be  done 
not  more  frequently  than  monthly. 

Illustrative  Problem.  Let  us  illustrate  this  general  plan  of  keep- 
ing statistical  subdivisions  of  our  asset  accounts  by  a  group  of 
transactions.  The  transactions  are  listed  first,  and  the  entries 
follow.  The  reader  is  advised  to  observe  the  first  transaction  and 
then  before  looking  at  the  corresponding  entry  in  the  second  table 
to  make  up  his  mind  what  should  be  debited  and  what  credited. 
After  a  few  trials  of  that  sort,  he  is  advised  to  reverse  the  process 
and  determine  from  the  entry  in  the  second  table  what  he  will  find 
as  a  transaction  in  the  first. 

(i)  We  invest  $8,000  in  cash 

(2)  We  pay  for  raw  material,  $5,000 

(3)  We  issue  $1,500  of  raw  material  to  the  shop  for  manufacture 

(4)  We  pay  wages,  $1,400 

(5)  We  pay  insurance,  $300 

(6)  We  pay  for  fuel,  $350 

(7)  We  pay  monthly  rent,  $200 

(8)  We  pay  for  general  monthly  factory  expenses,  $450 

(9)  We  find  that  we  owe  for  royalty  on  machinery  for  the  month,  $280 

(10)  We  send  to  the  warehouse  from  the  shop  finished  goods  that  cost  $1,800 

(11)  We  find  that  during  the  month  we  have  burned  $100  worth  of  coal 

(12)  We  find  that  $75  of  insurance  has  expired 


Debited 

(i)  Cash  8,000 

(2)  Raw  Material  5,000 

(3)  Goods-in-Process  1,500 

(4)  Wages  1,400 

(5)  Insurance  Prepaid  300 

(6)  Fuel  350 

(7)  Rent  200 

(8)  General  Expenses  450 

(9)  Royalties  280 

(10)  Finished  Goods  1,800 

(11)  Goods-in-Process  100 
(la)  Goods-in-Process  75 


Credited 
(i)  Proprietorship-Claim  8,000 


(2)  Cash 

5,000 

(3)  Raw  Material 

1,500 

(4)  Cash 

1,400 

(5)  Cash 

300 

(6)  Cash 

350 

(7)  Cash 

200 

(8)  Cash 

450 

(9)  Royalty  Liability 

280 

(10)  Goods-in-Process 

1,800 

(11)  Fuel 

100 

(12)  Insurance  Prepaid 

75 

58  THE  FUNDAMENTALS  OF  ACCOUNTING 

What  are  now  our  assets?  Let  us  look  at  our  individual  accounts 
and  see  what  balances  they  show.  For  convenience,  since  we  wish 
to  look  at  them  in  combination  rather  than  individually,  we  will 
examine  them  as  a  list  rather  than  in  ledger  form. 


Dr. 

Cr. 

Dr. 

Balance 

Cr. 

Balance 

Cash 

8,000 

7,700 

300 

Proprietorship-Claim 

8,000 

8,000 

Raw  Material 

5,000 

1,500 

3,500 

Goods-in-Process 

1,675 

1,800 

125 

Wages 

1,400 

1,400 

Insurance  Prepaid 

300 

75 

225 

Fuel 

350 

100 

250 

Rent 

200 

200 

General  Expenses 

450 

450 

Royalties 

280 

280 

Finished  Goods 

1,800 

1,800 

Royalty  Liability 

280 
19,455 

280 

19,455 

8,405 

8,405 

Bookkeeping  not  Complete.  This  at  once  discloses  what  would 
be  an  impossible  situation  if  our  books  were  complete.  Though 
our  debits  equal  our  credits,  as  they  must,  Goods-in-Process  shows 
a  credit  balance.  A  credit  to  an  asset  account  means  that  more 
has  been  given  up  than  received.  This  is  impossible,  of  course. 
This  at  once  suggests  that  our  bookkeeping  is  not  complete  —  or, 
better,  that  we  have  not  yet  combined  all  the  facts,  or  elements,  of 
Goods-in-Process  into  the  account  of  that  name  so  as  to  get  them 
together.  Examining  the  entries,  we  see  that  though  Goods-in- 
Process  has  been  credited  for  the  finished  goods  sent  from  the  shop 
to  the  warehouse,  it  has  never  been  debited  for  some  of  the  costs 
which  have  entered  into  both  goods  finished  and  goods  still  in 
process.  It  has  not  been  debited  for  wages,  or  rent,  or  general  ex- 
penses, or  royalties.  The  titles  of  the  accounts  in  which  these  items 
stand  suggest  that  the  accounts  are  subdivisions  of  Goods-in- 
Process,  representing  certain  elements  which  have  entered  into  our 
product,  and  that  they  must  now  be  consolidated  with  the  other 
items  already  included  in  Goods-in-Process. 

Transfer  of  Amounts  to  Goods-in-Process.  This  consolidation 
consists  merely  in  transferring  from  the  statistical  subdivisions  of 
Goods-in-Process,  Wages,  Rent,  General  Expenses,  and  Royalties,. 


THE  OPERATING  STATEMENT  59 

to  the  main  account,  Goods-in-Process,  the  amounts  in  the  sub- 
divisional  accounts.  When  we  have  an  item  on  the  debit  side  of 
an  account  and  wish  to  transfer  it  to  another  account,  so  that  the 
information  may  be  foimd  on  the  second  account  rather  than  on  the 
first,  we  of  course  debit  it  to  the  new  account  (since  it  was  a  debit 
that  was  transferred),  and  credit  it  to  the  old  account  (simply  can- 
celling the  debit  entry  to  the  old  account  by  an  item  on  the  side 
opposite  to  the  debit  that  has  been  transferred  —  for  we  do  not 
subtract  on  books  of  account  but  add  to  the  other  side,  by  a  debit 
or  credit,  as  explained  on  page  144).    The  actual  entries  follow: 


Debited 

Credited 

Goods-in-Process 

1,400 

Wages 

1,400 

Goods-in-Process 

200 

Rent 

200 

Goods-in-Process 

450 

Gen'l  Expenses 

450 

Goods-in-Process 

280 

Royalties 

280 

No  Transfer  of  Elements  not  yet  Used.  It  will  be  noted  also  that 
we  have  not  at  this  time  transferred  the  balance  of  Raw  Material, 
of  Insurance,  and  of  Fuel,  to  Goods-in-Process.  We  should  not  do 
so,  of  course,  for  not  all  the  raw  material  and  insurance  and  fuel 
have  been  consumed  in  producing  goods;  and  we  have  already,  by 
entries  #3,  #11,  and  #12  above,  transferred  to  Goods-in-Process  what 
has  been  consumed.  In  other  words,  we  determine  what  entries  to 
make  preparatory  to  the  drawing  up  of  the  balance  sheet  by  in- 
specting each  account  and  adjusting  it  to  the  present  situation  if  it 
has  not  already  been  adjusted.  Some  items  will  have  been  auto- 
matically adjusted,  because  current  information  was  needed,  and 
others  will  be  awaiting  adjustment. 

Balances.  At  this  point  we  may  well  observe  the  balances  of  our 
accounts  as  they  stand. 


Dr.  Balances 

Cr.  Balances 

Cash 

$  300 

Proprietorship-Claim 

$8,000 

Raw  Material 

3,500 

Goods-in-Process 

2,205 

Insurance  Prepaid 

22s 

Fuel 

250 

Finished  Goods 

1,800 

Royalty  Liability 

280 

$8,280 

$8,280 

6o  THE  FUNDAMENTALS  OF  ACCOUNTING 

What  Balances  Show.  Let  us  note  the  meaning  of  the  figures. 
The  proprietor  has  in  the  business  $8,000,  and  the  owners  of  the 
machinery  have  a  claim  to  $280,  or  a  total  of  ownership-claims  of 
$8,280;  and  those  claims  are  offset  by  the  assets.  These  assets, 
however,  consist  of  two  classes:  (i)  originally  purchased  insurance, 
fuel,  and  raw  material,  which  have  undergone  no  conversion  but 
still  remain  in  their  original  form;  and  (2)  converted  assets,  in  what 
are  now  partly  completed  and  wholly  completed  goods,  but  were 
not  long  ago  fuel  and  prepaid  insurance  and  services  of  employees, 
and  before  that  were  cash.  The  stages  of  conversion  of  this  last 
class  have  been  traced  along  the  whole  process  and  records  have 
been  preserved  statistically  by  the  way.  The  only  thing  we  might 
have  done  that  we  have  not  done  is  to  keep  the  record  of  conver- 
sion day  by  day,  but  this  is  not  worth  while.  Even  our  monthly 
subdivisional  figures,  like  wages  and  rent,  have  disappeared  from 
our  final  balances  but  remain  on  our  ledger  with  the  totals  of 
both  sides  equal  (and  hence  without  balances)  for  our  statistical  in- 
formation. If  we  should  now  list  the  balances  in  another  form,  sepa- 
rating the  names  of  the  accounts  into  two  long  columns,  one  for 
those  having  debit  balances  and  the  other  for  those  having  credit  bal- 
ances, we  should  have  a  balance  sheet.  In  fact  that  is  all  a  balance 
sheet  is  —  a  statement  of  ledger  balances  when  the  books  have  been 
brought  up  to  the  time  designated  as  the  date  of  the  balance  sheet. 

Relation  between  Principal  and  Subdivisional  Accounts.  The 
relation  between  our  principal  asset  accounts  and  our  subdivisional 
accounts  may  now  be  wisely  summarized.  The  simplest  method 
of  entry  is  to  debit  Goods-in-Process  and  credit  Cash  for  all  costs 
of  producing  goods  —  supposing  we  pay  cash  outright.  If  we  need 
more  information,  however,  as  we  do  for  a  statement  of  operations, 
we  may  well  make  the  record  in  two  processes  instead  of  one,  thus: 
(i)  Wages  debited  and  Cash  credited;  (2)  Goods-in-Process  debited 
and  Wages  credited.  The  Wages  items  cancel  each  other  and  leave 
no  balance,  but  they  remain  as  totals  and  so  give  us  our  statistical 
information.  In  similar  fashion  goods-in-process  get  converted 
into  finished  goods  and  become  recorded  on  our  books. 

Profit  and  Loss.  Let  us  now  continue  our  transactions  and  sell 
some  of  our  finished  goods.  Suppose  we  sell  goods  which  cost  us 
$1,200.    These  finished  goods  have  now  become  sold  goods,  and  so 


THE  OPERATING  STATEMENT  6 1 

we  shall  debit  Sold  Goods  and  credit  Finished  Goods.  For  the 
selling  process  some  other  transactions  will  necessarily  be  involved, 
like  selling  wages  and  advertising,  but  these  are  of  the  same  gen- 
eral type  as  those  of  the  manufacturing  process  and  we  will  omit 
them  here  —  though  we  shall  observe  them  later.  Suppose  the  sell- 
ing price  of  these  goods  is  $i ,700.  We  shall,  if  we  are  going  to  show 
our  records  completely,  now  debit  Accounts  Receivable  (or  Cash), 
$1,700,  and  credit  Sold  Goods  $1,200  and  Proprietor's  Profit-Claim 
$500.  Our  debits  and  credits  to  Sold  Goods  cancel  each  other,  and 
no  balance  remains  on  the  account,  though  the  total  shows  the  cost 
of  goods  handled.    Our  balance  sheet  will  now  look  as  follows: 

Cash  $    300    Royalty  Liability                             $    280 

Accounts  Receivable  1,700    Proprietorship-Claim  (Investment)    8,000 

Finished  Goods  600    Proprietor's  Profit-Claim                      500 

Goods-in-Process  2,205 

Raw  Material  3,S00 

Fuel  250 

Insurance  Prepaid  225 


$8,780  $8,780 

Even  if  the  goods  had  been  sold  for  less  than  they  cost,  the  credit  to 
Sold  Goods  would  have  to  equal  the  debit,  because  the  goods  have 
been  disposed  of:  and  Proprietorship-Claim  would  be  debited  for 
the  loss  —  that  and  Accounts  Receivable  together  debited  for 
the  amount  of  credit  to  Sold  Goods. 

Basic  Method  of  Recording  Assets.  This  is  the  method,  with 
some  modifications  of  detail  to  be  discussed  later,  used  by  most 
well  organized  manufacturing  houses.  A  few  primary  facts  about 
it  should  be  noted.  It  is  based  on  the  fact  that  expenditures  are 
not  made  ordinarily  in  vain,  but  for  a  return,  and  that  therefore  the 
assets  given  up  in  one  form  are  received  back  in  another  (converted 
into  that  other  by  business  processes).  It  is  based  on  the  need  of 
having  assets  that  are  in  recognizable  form  reported  on  the  books  as 
in  that  form  —  as  Fuel,  Raw  Material,  Goods-in-Process,  Finished 
Goods.  It  recognizes,  however,  that  the  effort  to  show  current 
changes  of  form,  as  the  conversion  of  fuel  into  goods-in-process, 
would  entail  needless  labor.  It  therefore  continues  on  the  books, 
as  if  in  original  form,  many  assets  even  after  they  have  lost  their 
original  forms,  and  adjusts  the  record  to  the  facts  periodically. 

Variation  Usual.    A  variation  of  this  method  is  desirable  and 


62  THE  FUNDAMENTALS  OF  ACCOUNTING 

usual  for  the  sake  of  saving  bookkeeping  labor.  Obviously  it  is  not 
necessary  in  connection  with  each  sale  to  record  immediately  on  the 
ledger  just  how  much  profit  that  sale  yielded.  Such  information 
should  be  preserved  in  subordinate  records  ready  for  final  incor- 
poration in  the  proprietor's  profit-claim  account  at  such  times  as 
the  books  are  to  be  brought  up  to  a  definite  date.  Hence  it  is  cus- 
tomary not  to  split  sales  into  their  two  parts :  that  part  which  repre- 
sents an  exact  exchange  of  one  asset  (finished  goods)  for  another 
(cash,  or  accounts  receivable)  at  the  same  value,  and  that  part 
which  is  profit.  Customarily  when  a  sale  is  made  the  credit  is  to 
Sold  Goods,  or  Sales  (as  the  account  is  more  commonly  called),  for 
the  total  amount  of  the  sale.  Then  the  credit  to  that  account 
represents  partly  the  giving  up  of  an  asset  (goods  sold)  and  partly 
proprietor's  profit-claim.  Theoretically  this  double  aspect  of  the 
account  is  unfortunate,  for  it  does  not  distinguish  fundamentally 
different  things,  but  practically  it  is  desirable,  for  it  both  gives  a 
saving  of  labor  (since  by  it  many  profits  may  be  consolidated  and 
transferred  to  the  profit  account  in  one  lump  sum),  and  provides  us 
with  the  statistical  figure  for  the  total  volume  of  sales  at  selling 
price.  When  profits  are  carried  to  the  profit  account  directly,  with 
only  the  cost  portion  of  sales  passing  through  the  sales  account 
(both  debited  and  credited),  nowhere  will  the  books  show  the  total 
volume  of  sales.  The  shorter  method  produces  no  confusion;  for 
though  the  debit  side  represents  costs,  or  assets  at  cost,  and  the 
credit  side  both  giving  up  of  assets  and  profits,  the  difference  be- 
tween the  two  sides  always  represents  profits  (or  losses,  if  the  bal- 
ance is  on  the  debit  side),  and  all  that  needs  to  be  done  to  complete 
the  bookkeeping  is  to  transfer  the  balance  of  the  sales  account  to 
the  proprietor's  account  (distinguishing  his  profit-claim  from  his 
investment  account  by  a  separate  title  —  though  the  two  may  be 
consolidated  after  the  figure  has  been  once  entered  for  record). 
Thus  if  goods  costing  $1,200  are  sold  for  $1,700,  the  entries  involved 
by  the  long  method  would  be  as  follows: 

Debited  Credited 

Sold  Goods  1,200       Finished  Goods  1,200 

Accts.  Receivable  1,700     j  ^""^l^^^'  '''°° 

"  i  Profit-Claim  500 

The  three  entries  involved  by  the  short  method  follow: 


Debited 

Credited 

Sold  Goods 

$1,200 

Finished  Goods 

Accts.  Receivable 

1,700 

Sold  Goods 

Sold  Goods 

500 

Profit-Claim 

THE  OPERATING  STATEMENT  63 

$1,200 

1,700 

500 

The  last  entry  is  merely  to  transfer  the  balance  of  Sold  Goods  to 
Profit-Claim.  What  is  called  the  short  way  above  looks  longer,  for 
it  appears  to  have  more  entries;  but  it  should  be  remembered  that 
the  last  pair  of  debits  and  credits  is  made  only  once  for  the  whole 
period,  whereas  all  the  other  entries  are  made  for  each  sale.  If 
there  were  one  hundred  sales,  therefore,  there  would  be  by  the  long 
method  two  hundred  debits  and  three  hundred  credits,  or  a  total  of 
five  hundred,  but  by  the  short  method  two  hundred  one  debits  and 
two  hundred  one  credits,  or  a  total  of  four  hundred  two;  and  each 
credit  to  Profit-Claim  by  the  long  method  would  have  to  be  found 
by  performing  a  subtraction  of  cost  from  selling  price,  or  one  hun- 
dred subtractions  in  all,  whereas  by  the  short  method  one  subtrac- 
tion (total  cost  from  total  selling  price)  suffices.  This  short  method 
is  consistent  with  our  theory  of  debit  and  credit,  as  expounded  in 
Chapter  IV,  that  all  credits  indicate  either  reduction  in  assets  or 
increase  in  ownership-claim;  for  here  our  credit  to  sales  is  in  part 
for  reduction  in  assets  (the  cost  of  the  goods  sold),  and  in  part  for 
increase  in  ownership-claim  (profits) ;  or  if  a  loss  has  been  suffered, 
the  credit  to  Sales  is  for  less  than  the  cost,  and  hence  Sales  has  a 
debit  balance  (since  it  was  debited  at  the  cost  of  the  goods),  and 
this  debit  balance  now  represents  a  reduction  in  ownership-claim 
(as  our  theory  of  debit  and  credit  shows  us  that  a  debit  may  do). 
The  Operating  Statement.  Let  us  now  see  an  operating  state- 
ment for  this  period,  drawn  from  the  detailed  accounts  and  not 
from  the  balance  sheet.  The  latter  shows,  it  will  be  remembered, 
our  status  at  the  end  of  the  time;  but  the  operating  statement 
shows  chiefly  how  the  change  in  our  proprietorship  status,  as  com- 
pared with  that  of  the  preceding  period,  was  brought  about,  and 
can  be  got  from  the  ledger  accounts.  First,  we  must  note  that 
what  we  wish  to  show  is  (i)  the  cost  of  all  assets  that  have  been 
converted  from  original  forms  into  other  forms,  and  (2)  the  value 
received  from  those  converted  forms,  with  (3)  the  net  profit  or 
loss  from  the  conversion.  All  ledger  balances,  now  that  the  books 
have  been  brought  up  to  the  time,  belong  on  the  balance  sheet  as 
assets  or  ownership-claims,  but  many  accounts  without  present 


64  THE  FUNDAMENTALS  OF  ACCOUNTING 

balances,  and  hence  not  on  the  balance  sheet  at  all,  give  us  in- 
formation regarding  operations,  and  figures  from  them  go  upon 
the  operating  statement  to  show  what  items  of  converted  assets 
brought  in  the  returns  from  conversions  —  what  items  of  assets 
in  original  form  went  to  create  by  conversion  the  assets  received 
from  conversion,  and  hence  are  ultimately  cancelled  on  the  books 
by  transfer  to  other  accounts.  The  present  totals  of  ledger  ac- 
counts shown  below  are  taken  before  the  last  entry  transferring 
to  Proprietor's  Profit-Claim  the  balance  on  Sales,  for  on  the 
operating  statement  we  wish  to  show  that  profit  in  connection 
with  the  sales  account  rather  than  with  the  proprietor's  account. 

Proprietorship-Claim 

Cash 

Accounts  Receivable 

Raw  Material 

Goods-in-Process 

Wages 

Insurance  Prepaid 

Fuel 

Rent 

General  Expenses 

Royalties 

Finished  Goods 

Royalty  Liability 

Sales 


The  operating  statement  given  by  these  figures  follows. 
Merchandise  Operating  Statement 


Dr. 

Cr. 

8,000 

8,000 

7,700 

1,700 

5,000 

1,500 

4,005 

1,800 

1,400 

1,400 

300 

75 

350 

100 

200 

200 

450 

450 

280 

280 

1,800 

1,200 

280 

1,200 

1,700 

24,68s 

24,685 

Sales 

$1,700 

Raw  Material  consumed 

$1,500 

Wages 

1,400 

Rent 

200 

General  Expenses 

450 

Royalties 

280 

Fuel 

100 

Insurance 

75 

Cost  of  manufacturing 

$4,005 

Goods-in-Process  at  end 

$2,205 

Finished  Goods  at  end 

600 

Product  unsold 

$2,805 

2,805 

Cost  of  goods  sold 

$1,200 

1,200 

Net  Profit 

$500 

THE  OPERATING  STATEMENT  65 

Let  us  now  trace  the  origin  of  each  figure  on  the  operating  state- 
ment. The  sales  item  is  the  credit  to  Sales;  raw  material  con- 
sumed is  the  credit  to  Raw  Material,  which  was  made  when 
Goods-in-Process  was  debited  for  material  converted;  the  wages 
item  is  the  credit  to  Wages  (and  as  the  total  debit  to  wages  was 
chargeable  to  manufacturing  costs,  the  transfer  wipes  out  the  ac- 
count) ;  the  rent  item  is  the  credit  to  Rent  (which  is  now  wiped 
out) ;  similarly,  the  items  for  general  expenses,  royalties,  fuel,  and 
insurance,  are  the  credits  to  General  Expenses,  Royalties,  Fuel, 
and  Insurance  Prepaid,  respectively,  for  these  credits  show  how 
much  of  the  various  debits  were  found  chargeable  to  manufac- 
turing processes  (and  the  balances  on  Fuel  and  Insurance  Prepaid 
represent  values  not  yet  converted  and  hence  now  on  the  balance 
sheet);  the  cost  of  manufacturing  is  the  total  of  the  elements 
shown,  and  it  is  proved  by  its  agreement  with  the  debit  to  Goods- 
in-Process  on  the  ledger;  the  goods  in  process  at  the  end  is  the 
balance  on  Goods-in-Process,  in  agreement  with  the  balance 
sheet;  the  finished  goods  at  the  end  is  the  balance  in  agreement 
with  the  balance  sheet;  the  product  unsold  is  the  sum  of  the  two 
preceding  items;  the  cost  of  goods  sold  is  the  difference  between 
manufacturing  cost  and  product  unsold,  and  it  is  proved  by  its 
agreement  with  the  debit  to  Sales;  the  net  profit  is  the  difference 
between  the  cost  of  goods  sold  and  sales,  and  it  is  proved  by  its 
agreement  with  the  balance  of  Sales,  which  is  to  be  transferred 
ultimately  as  proprietor's  profit-claim. 

Comparison  with  Income  Sheet.  A  comparison  of  this  operating 
statement  with  the  income  sheet  on  page  46  shows  by  how  much 
we  have  carried  our  analysis  beyond  the  first  stages.  On  the  in- 
come sheet,  we  have  only  one  item  for  profit  on  merchandise,  $500. 
Here  that  $500  is  made  up  of  thirteen  details.  How  much  more 
valuable  the  later  statement  is  than  the  earlier  for  guidance  in  con- 
ducting the  business  is  sufficiently  obvious.  To  get  a  complete 
operating  statement,  of  course,  the  other  items  of  income  and  loss 
given  on  the  earlier  income  sheet  should  be  added  to  the  mer- 
chandise operating  statement,  so  that  it  would  be  identical  with  the 
income  sheet  given  on  page  46  except  for  the  substitution  of  the 
merchandise  operating  statement  above  for  the  single  item  *' Profit 
on  merchandise."    The  practice  of  distinguishing  between  an  in- 


66  THE  FUNDAMENTALS  OF  ACCOUNTING 

come  sheet  and  an  operating  statement,  as  indicated  above,  is  not 
universal,  but  in  general  a  report  of  income  in  brief  form,  as  first 
shown,  is  called  an  "  income  sheet,"  whereas  only  the  fuller  form 
should  be  called  an  ''  operating  statement.'' 

When  Entries  are  Made.  We  have  observed  that  many  ac- 
counts are  not  kept  up  to  the  times,  for  they  do  not  need  frequent 
observation  and  to  keep  them  up  to  the  times  would  mean  much 
unnecessary  bookkeeping  labor.  Question  at  once  arises  as  to 
when  entries  should  be  made.  Unless  we  have  some  definite  plan, 
we  may  omit  or  repeat  items.  We  saw  on  page  37  that  if  we  incur 
a  liability  for  an  asset  we  may  either  enter  the  transaction  immedi- 
ately, debiting  the  asset  and  crediting  the  liabiUty,  or  we  may  post- 
pone entry  until  the  debt  is  paid,  when  we  debit  the  asset  and 
credit  cash.  Which  of  these  we  shall  do  depends  on  the  timeliness 
that  we  require  of  our  records :  if  we  wish  the  asset  to  show  at  once, 
we  must  make  the  entry  at  the  time  of  purchase,  whether  we  care 
about  the  immediate  showing  of  the  liability  or  not;  and  if  we  wish 
the  liability  to  show  at  once,  we  must  make  the  entry  at  once  even 
though  we  have  no  immediate  need  for  the  asset;  but  if  we  care 
about  neither  currently  (because  the  items  are  small,  or  the  liabihty 
is  not  due  for  a  long  time,  or  the  assets  do  not  need  watching),  we 
may  postpone  entry  until  payment  is  made.  In  preparing  the 
books  for  the  income  sheet  and  the  balance  sheet,  however,  care 
must  be  taken  that  entries  are  made  to  bring  everything  up  to  the 
times,  for  not  only  assets  and  liabilities  but  costs  and  earnings  must 
now  be  incorporated  on  the  books.  This  means  sometimes  that 
the  bookkeeper  must  look  back  and  see  when  certain  items  were 
last  brought  up  to  the  times.  The  date  of  the  last  entry,  moreover, 
is  not  necessarily  the  date  of  the  last  adjustment;  for  certain  trans- 
actions may  require  entry  at  certain  times  even  though  earlier 
items  have  not  yet  been  entered  and  do  not  need  entry.  A  good 
illustration  of  this  is  interest  on  borrowed  money.  Suppose  we 
owe  on  two  notes,  and  interest  on  #1  falls  due  March  i  and  Sep- 
tember I,  and  on  #2  falls  due  May  i  and  November  i.  When  we 
pay  interest  on  #1  on  September  i,  interest  has  already  accrued  on 
#2  since  May  i ;  but  we  do  not  need  to  enter  the  interest  on  #2  on 
that  day  unless  we  are  bringing  our  books  up  to  the  times  on  that 
day,  though  we  must  enter  the  interest  on  #1  in  order  to  show  what 


THE  OPERATING  STATEMENT  67 

has  happened  to  our  cash.  On  November  i,  moreover,  when  we 
pay  interest  on  #2,  interest  has  accrued  on  #1  since  September  i; 
but  we  do  not  need  to  enter  it  unless  for  some  special  reason.  In 
other  words,  if  an  account  is  not  of  a  sort  to  be  inevitably  kept 
currently,  only  an  examination  of  the  items  will  show  whether  it 
is  current  at  any  particular  time.  When,  then,  should  entries  be 
made?  As  a  rule,  whenever  transactions  culminate  —  i.e.,  when- 
ever a  natural  period  has  been  reached,  such  as  a  definite  dealing  or 
settlement.  Closing  a  financial  period  is,  of  course,  such  a  culmi- 
nation, as  are  payments  and  adjustments.  Other  matters,  such  as 
accruals  not  paid,  depreciation,  expiration  of  insurance,  etc.,  must 
be  entered  according  to  the  need  of  the  case  —  and  such  a  need  al- 
ways arises  from  some  sort  of  culmination  of  circumstances,  such 
as  wishing  information  of  some  type  complete  to  a  certain  point. 

QUESTIONS  AND  PROBLEMS 

1.  As  manager  of  a  business  should  you  be  primarily  interested  in  the 
operating  statement  or  in  the  income  sheet?  Why?  In  which  state- 
ment should  you  be  primarily  interested  if  you  were  a  stockholder  in 
the  business,  and  why? 

2.  It  has  been  said  that  many  accounts  are  kept  for  elements  of  goods-in- 
process,  and  that  though  the  elements  soon  lose  their  identity,  the  ac- 
counts are  kept  as  if  the  assets  which  they  represent  were  in  their  origi- 
nal form,  so  that  we  may  have  the  statistical  record  of  their  existence. 
What  is  meant  by  "statistical  record"  and  what  is  its  value? 

3.  In  191 9  the  output  of  "a  business  was  200,000  articles  of  a  single  type, 
the  factory  pay  roll  was  $500,000,  and  the  average  pay  was  $2,000  an- 
nually. In  1920  the  output  was  216,000  articles,  the  factory  pay  roll 
was  $720,000,  the  average  pay  was  $3,000,  and  the  conditions  of  pro- 
duction in  other  respects  were  unchanged,  (a)  Was  the  labor  more  or 
less  efficient  absolutely,  irrespective  of  pay,  in  1920?  (b)  Was  the  la- 
bor element  of  cost  lower  or  higher  per  unit  of  production?  (c)  If  in 
1920  the  average  wages  had  been  $2,400,  the  total  pay  roll  and  the  to- 
tal output  remaining  unchanged,  what  would  your  answers  have  been 
to  (a)  and  (b)?  (d)  If  in  1920  the  production  had  been  300,000  arti- 
cles, the  average  pay  $3,000,  and  the  total  pay  roll  still  $720,000,  what 
would  your  answers  have  been? 

4.  If  accounts  are  kept  by  the  cost-accounting  method  described  in  this 
chapter,  and  posting  has  been  completed,  what  is  represented  by  the 
balance  of  each  of  the  following  accounts  (i)  before  the  accounts  are 
adjusted  to  the  time,  and  (2)  after  they  are  so  adjusted? 

(a)  Raw  Material  (d)  Goods-in-Process 

(b)  Fuel  (e)  Insurance  Prepaid 

(c)  Finished  Goods 


68  THE  FUNDAMENTALS  OF  ACCOUNTING 

5.  A  business  buys  many  of  the  parts  of  its  finished  product  from  other 
manufacturers  and  then  combines  the  parts  with  new  raw  material. 
Construct  entries  for  the  transactions  following,  and  carry  the  final 
profit  to  the  proprietor.  Record  profit  on  sales  by  the  short-cut 
method.    [The  profit  is  $310.] 

The  balance  sheet  at  the  beginning  of  the  period  is: 

Cash  $  8,000        Proprietor  $15,000 

Plant  12,000        Accounts  Payable         5,000 

$20,000  $20,000 

Raw  materials  are  purchased  for  cash,  $5,000,  and  finished  parts  on 
account,  $3,000. 

In  the  process  of  manufacture  the  following  expenses  are  incurred: 
wages  paid  in  cash,  $500;  insurance,  paid,  $100;  taxes,  accrued  but  not 
paid,  $30;  supplies,  bought  on  account,  $10;  depreciation  of  plant,  $50. 
Raw  materials,  $2,000,  and  purchased  parts,  $1,000,  are  requisitioned 
from  the  store  house  for  manufacture. 

The  goods  are  now  found  to  be  completed,  and  are  sold  for  $4,000  — 
cash,  $2,000,  on  account,  $2,000.  The  insurance  is  found  to  be  ex- 
pired, and  the  suppUes  to  be  exhausted,  and  there  are  no  liabilities  not 
shown  on  the  books. 

6.  Show  the  ledger  accounts  and  final  balance  sheet  for  the  business  in 
problem  5. 

7.  The  following  figures  are  found  on  the  accounts  of  a  business  when  all 
the  adjustment  entries  except  the  last  have  been  made. 

(a)  Show  what  should  be  debited  and  what  credited  preparatory  to 
drawing  up  the  balance  sheet. 

(b)  Construct  from  the  figures  the  statements  for  the  manager. 

Proprietor 

Accounts  Receivable 

Accounts  Payable 

Real  Estate 

Cash 

Wages 

Power 

Fuel 

Raw  Material 

Other  Costs 

Goods-in-Process 

Finished  Goods 

Sales 


Debits 

Credits 

$S,ooo 

$68,000 

30,000 

24,500 

10,000 

25,000 

18,000 

18,000 

3,200 

3,200 

1,800 

1,600 

40,000 

28,000 

500 

500 

51,300 

40,000 

40,000 

30,000 

30,000 

41,000 

$254,800 

$254,800 

CHAPTER  VII 

THE  OPERATING  STATEMENT  —  UNDER 
THE  INVENTORY  METHOD 

The  Inventory  Method.  We  have  so  far  assumed  that  the  factory 
has  a  cost-accounting  method  that  enables  it  to  know  the  cost  of 
each  manufacturing  step  for  the  goods  sold,  and  hence  is  able  to 
carry  those  costs  along  day  by  day  from  the  shop  through  Finished 
Goods  and  Sold  Goods,  and  thus  learns  profits  on  specific  items  of 
sales.  Let  us  now  suppose  this  is  not  the  case.  Let  us  suppose 
that  it  has  not  taken  the  trouble  to  learn  how  much  of  its  total 
expenditure  for  raw  material,  for  labor,  for  fuel,  etc.,  goes  into  any 
particular  product,  and  so  it  has  not  debited  Goods-in-Process 
for  the  cost  elements  involved;  then  it  cannot  know  directly  how 
much  of  each  or  of  all  of  them  has  gone  into  the  product  of  a 
month.  This,  as  a  matter  of  fact,  is  the  truth  about  many  busi- 
nesses. How  may  we  know  how  much  value  in  raw  materials,  for 
example,  went  into  the  goods-in-process  in  a  month?  Supposing 
none  were  lost  or  stolen,  it  is  obvious  that  the  total  on  hand  at  the 
beginning  of  the  month,  plus  the  purchases,  minus  the  total  on 
hand  at  the  end  of  the  month,  is  the  amount  sent  to  the  shop  for 
manufacturing.  In  other  words,  we  do  for  raw  materials  exactly 
what  we  did  in  the  other  case  for  fuel  and  insurance  —  determine 
the  consumption  by  comparing  the  total  available  with  what  is  left 
at  the  end.  How  do  we  find  the  value  of  goods  finished  in  the 
month?  We  resort  to  the  same  method  of  inventory.  We  begin 
with  the  value  of  goods-in-process  at  the  beginning  of  the  month, 
add  all  the  elements  that  have  gone  into  goods  during  the  month 
(fuel,  wages,  insurance,  rent,  etc.),  and  subtract  the  value  of  goods- 
in-process  at  the  end  of  the  month:  the  balance  is  the  cost  of  goods 
finished  in  the  month  —  for  all  we  started  with,  plus  all  we  added, 
minus  what  we  have  left,  must  be  what  we  took  out.  By  the  same 
sort  of  process  appUed  to  finished  goods,  we  can  find  the  cost  of 
goods  sold.  Then  a  comparison  of  selling  prices  with  costs  shows 
us  our  profit.  This  is  obviously  a  much  more  clumsy  way  of  learn- 
ing profits  than  the  other.  It  is  particularly  likely  to  err  because  it 
hinges  very  largely  on  the  skill  with  which  the  valuation  of  goods- 


70  THE  FUNDAMENTALS  OF  ACCOUNTING 

in-process  is  made  —  for  only  by  aid  of  that  valuation  can  one 
learn  the  cost  of  finished  goods  and  of  sold  goods.  If  the  valuation 
put  on  the  goods  at  the  end  is  too  high,  the  profit  will  be  overstated, 
for  by  the  same  amount  the  cost  of  the  goods  finished  and  sold  will 
be  stated  too  low.  Yet  goods-in-process  are  peculiarly  hard  to 
value.  How  shall  we  know  whether  the  manufacturing  is  half 
done  or  three-eighths  done?  Indeed,  evaluation  usually  involves 
reasoning  in  a  circle.  Even  if  one  could  know,  moreover,  how  can 
one  find  the  cost,  for  instance,  of  a  bicycle  haK  finished  when  the 
cost  of  a  finished  bicycle  is  unknown  and  the  cost  of  one  half  fin- 
ished is  itself  a  means  of  learning  the  cost  of  one  finished?  Hence 
the  method  which  keeps  costs  item  by  item  up  to  the  finish  is  the 
only  satisfactory  method.  Since  it  is  not  always  practicable,  how- 
ever, because  expensive,  we  must  be  satisfied  in  many  cases  with 
the  crude  method  of  finding  only  total  costs  at  the  end  of  long  pe- 
riods rather  than  individual-item  costs  at  the  end  of  short  periods. 
The  Costs.  Now  let  us  see  how  this  is  done.  We  have  seen  that 
we  cannot,  because  information  is  lacking  in  such  cases,  periodically 
charge  Goods-in-Process,  or  Finished  Goods,  or  Sold  Goods,  the 
exact  costs:  we  must  charge  them,  if  at  all,  at  rather  long  intervals 
on  the  strength  largely  of  estimates  of  the  value  of  unfinished  goods 
at  the  time.  By  the  cost-accounting  method,  it  will  be  remem- 
bered, we  charged  first  the  elements  of  goods-in-process,  and  then 
Goods-in-Process,  and  Finished  Goods,  and  Sold  Goods,  all  at  ac- 
curately known  figures;  and,  as  a  part  of  this  process,  the  original 
elements  of  which  our  new  assets  were  made  up  were  transferred  on 
our  books  from  time  to  time  as  we  went  along,  leaving  no  balances, 
though  the  totals  preserved  our  statistics.  Now,  however,  the  at- 
tempt to  follow  through  all  the  steps  in  the  process  with  only  esti- 
mated or  approximate  figures  would  be  rather  ridiculous.  It  is 
wiser,  as  we  cannot  now  know  the  details  of  the  steps,  to  give  up  the 
attempt  to  record  those  steps  and  come  merely  to  final  results.  We 
shall  be  less  likely  to  err  if  we  look  at  our  condition  at  the  end  of  the 
journey  than  if  we  try  to  think  back  and  estimate  and  record  our 
condition  at  each  step  along  the  way.  We  know  our  original  start- 
ing point  (our  balance  sheet  at  the  beginning),  we  know  what  assets 
we  have  given  up  or  acquired  by  the  way  and  what  transactions 
they  entered  into,  and  we  can  by  examination  of  the  present  condi- 


THE  OPERATING  STATEMENT  7I 

tion  of  specific  accounts  find  our  general  condition  at  the  end.  We 
will  not  attempt  to  record  all  changes  in  Goods-in-Process,  from 
our  accounts  representing  the  elements  of  the  goods,  nor  in  Fin- 
ished Goods  from  Goods-in-Process,  nor  in  Sold  Goods  from  Finished 
Goods,  for  we  know  that  the  figures  are  now  too  late  to  have  any 
practical  significance.  We  will  short-cut  the  whole  thing,  and  con- 
solidate the  accounts  representing  the  elements  of  our  goods,  ex- 
cept for  the  balances  still  on  hand,  directly  in  final  accounts  as  if 
there  had  been  no  intermediate  stages.  The  first  step  is  to  see 
what  is  now  on  hand  of  various  types  of  assets,  and  then  to  see  that 
that  amount  on  hand  is  on  the  accounts  representing  those  assets  — 
left  there  if  already  there,  or  put  there  if  not  now  there;  and  finally 
we  transfer  to  Sold  Goods  all  balances  on  asset  accounts  not  repre- 
sented by  assets  actually  remaining  on  hand;  for  these  are  the  costs 
of  manufacturing  and  selling  the  goods. 

Illustration.  Let  us  try  this  method  for  the  situation  given  in 
the  last  chapter,  and  then  compare  the  result  with  that  of  the 
other  method.  Since  by  this  method  we  have  not  certain  informa- 
tion that  was  available  under  the  other  method,  we  shall  have 
original  entries  slightly  different  from  those  on  page  57.  Trans- 
actions 3, 10,  II,  and  12  are  not  now  known  to  us:  instead  of  them 
we  shall  learn,  by  taking  account  of  stock,  that  $3,500  of  raw 
material  is  on  hand  and  $250  of  fuel  is  on  hand,  and  we  shall  learn, 
as  before,  that  of  the  insurance  $75  has  expired  and  $225  remains. 
The  entries  that  we  shall  make,  during  the  period,  from  the  infor- 
mation gathered  during  the  period  are  as  follows: 


Debited  \ 

Credited 

Cash  ' 

$8,000 

Proprietorship-Claim 

$8,000 

Raw  Material 

S,ooo 

Cash 

S,ooo 

Wages 

1,400 

Cash 

1,400 

Insurance  Prepaid 

300 

Cash 

300 

Fuel 

350 

Cash 

350 

Rent 

200 

Cash 

200 

General  Expenses 

450        ^ 

Cash 

450 

Royalties 

280 

Royalty  Liability 

280 

We  must  now  prepare  the  books  for  the  balance  sheet  and  the  oper- 
ating statement.  Cash  of  $300  is  already  on  the  books  at  the  right 
figure,  and  hence  needs  no  attention:  as  it  is  still  on  hand  it  has  not 
been  consumed  or  converted  in  producing  goods.    Our  ledger  now 


72  THE  FUNDAMENTALS  OF  ACCOUNTING 

shows  us  Raw  Material  $S,ooo  and  we  wish  to  reduce  this  to  $3,500 
ior  the  present  status.  So  we  must  credit  Raw  Material  $1,500, 
for  this  is  the  amount  converted.  Since  we  do  not  know  how  much 
of  this  went  to  sold  goods,  how  much  to  finished  goods  not  sold,  and 
how  much  to  goods  still  in  process,  we  do  not  know  how  much  to 
debit  to  each  of  the  accounts  representing  these  things.  As  we  are 
in  suspense  on  this  matter,  we  may  as  a  matter  of  fact  set  up  an 
account  temporarily  for  such  items  of  suspended  information  and 
call  it  "  Converted  Assets."  We  know  that  the  raw  material  went 
into  some  goods  (supposing  none  was  lost  or  stolen),  and  we  may 
temporarily  debit  Converted  Assets  and  credit  Raw  Material  for 
the  amount.  The  same  sort  of  thing  is  true  of  $100  for  fuel  (for 
though  our  books  show  $350,  we  find  only  $250  worth  on  hand, 
and  know  that  $100  worth  has  been  converted)  and  of  $75  for  in- 
surance :  these  have  gone  into  unidentified  assets.  So  we  may  also 
debit  Converted  Assets  $175,  and  credit  Fuel  $100  and  Insurance 
Prepaid  $75.  In  addition,  finally,  we  must  cover  the  costs  wholly 
consumed  —  that  is,  all  the  costs  of  wages,  rent,  general  expenses, 
and  royalties.  These  may  be  entered,  grouping  all  entries  in  the 
converted  assets  account,  as  follows: 


Debited 

Credited  - 

Raw  Material 

1,500 

Fuel 

100 

Insurance  Prepaid 

75 

Converted  Assets 

4,005 

Wages 

1,400 

Rent 

200 

General  Expenses 

450 

Royalties 

280 

So  much  for  costs.  The  next  step  is  to  find  the  inventories  not  al- 
ready known  —  for  goods-in-process  and  finished  goods.  We  find 
on  examining  the  goods-in-process  and  the  finished  goods  that  we 
have  $2,205  o^  goods-in-process  on  hand  and  $600  of  finished  goods. 
These  last  two  figures  are  obtained  not  from  the  books,  for  the 
books  have  no  such  figures,  but  from  observation  and  estimate;  and 
as  already  indicated  they  are  hard  to  get  and  likely  to  err;  but  for 
the  sake  of  comparing  methods  we  will  here  assume  that  we  get  the 
same  figures  as  were  shown  on  the  books  by  the  other  method. 
Under  this  method,  we  do  not  know  from  just  what  specific  expen- 
ditures these  assets  came  —  from  just  what  raw  material  or  fuel, 


THE  OPERATING  STATEMENT  73 

for  example.  We  do  know,  however,  that  they  with  the  goods 
sold  make  up  the  total  of  our  assets  converted  by  manufacturing 
processes  into  new  forms  from  the  old.  Indeed,  they  make  up  our 
Converted  Assets.  Knowing,  as  we  do  from  the  figures  found 
above,  that  the  total  converted  assets  cost  $4,005,  and  knowing  as 
we  do  from  our  inventories  that  the  goods-in-process  and  finished 
goods  unsold  together  amount  to  $2,805,  we  now  know  that  the 
cost  of  goods  sold  is  $1,200,  or  $4,005  minus  $2,805.  We  wish 
now  to  show  on  our  books  the  cost  of  goods-in-process,  finished 
goods,  and  sold  goods;  and  since  we  have  combined  the  total  of  the 
elements  of  cost  of  all  of  them  as  a  debit  to  Converted  Assets,  we 
should,  now  that  we  know  the  final  result,  transfer  that  total  to 
the  various  accounts  representing  the  new  assets  taking  the  place 
of  the  old.  This  is  done  by  transfer  entries  similar  in  nature  to  the 
transfer  entries  shown  previously,  thus: 

Debited  Credited 

Goods-in-Process  2,205^ 

Finished  Goods  600  \    Converted  Assets      4,005 

Sold  Goods  1, 200 J 

Now,  of  course.  Converted  Assets  stands  debited  and  credited  for  the 
same  figure  and  is  without  balance  in  the  end.  Indeed,  it  is  quite  as  if 
it  had  had  no  entries  at  all ;  for  we  have  debited  it  for  all  the  costs  and 
pedited  it  for  the  conversion,  at  the  same  figure,  of  those  same  costs, 
and  the  net  result  is  the  same  as  if  we  had  debited  our  final  asset 
accoimts  and  credited  our  cost  accounts  in  the  first  instance.  The 
only  reason  we  used  this  account  was  to  show  that  under  this  method 
we  could  not  ascribe  certain  specific  costs  to  certain  specific  assets 
but  must  set  off  all  costs  together  against  all  the  produced  assets  to- 
gether. Our  Converted  Assets  now  stands  as  follows  on  the  ledger 
•—  the  items  on  the  left  showing  the  details  for  which  it  was  debited, 
and  those  on  the  right  showing  the  details  for  which  it  was  credited: 
Converted  Assets 


Raw  Material 

1,500 

Goods-in-Process 

2,205 

Fuel 

100 

Finished  Goods 

600 

Insurance  Prepaid 

75 

Sold  Goods 

1,200 

Wages 

1,400 

Rent 

200 

General  Expenses 

450 

Royalties 

280 

4,005 

4,005 

74  THE  FUNDAMENTALS  OF  ACCOUNTING 

The  Profit  and  Loss.  Under  the  cost-accounting  method  of 
handling  sold  goods,  as  described  on  pages  62-63,  as  will  be  re- 
membered. Sold  Goods  is  debited  currently  for  the  cost  of  goods 
sold  (for  the  cost  is  known  and  carried  through  to  the  sale) ;  and 
the  credit  for  sales  is  not  divided  for  each  sale  between  that  part 
which  is  conversion  of  an  old  asset  at  cost  and  that  part  which  is 
profit,  but  the  total  selling  price  is  credited  to  Sold  Goods  and  only 
at  the  end  of  a  period  is  the  division  made  between  that  part  which 
is  cost"(as  shown  by  the  debit  side  of  the  account)  and  that  which 
is  profit.  Under  the  inventory  method,  however,  since  the  cost  of 
individual  sales  is  not  known.  Sold  Goods  or  Sales  cannot  be  deb- 
ited currently  for  the  cost  of  goods  sold,  nor  can  the  gain  be  de- 
termined for  each  item  of  sales  even  if  that  is  desired.  Hence 
under  this  method  the  only  way  of  handling  items  of  sales  is  to 
credit  Sales  for  the  selling  price.  Then  a  comparison  of  the 
costs  debited  to  Sales  in  total,  as  found  by  the  method  shown 
on  page  73,  and  the  total  credits  for  selling  prices  gives  the 
profit  or  the  loss  on  goods  sold;  in  other  words,  the  balance  of 
this  account  is  the  profit  or  loss,  and  it  maybe  transferred  to  the 
proprietor's  account  by  transfer  entries  similar  to  those  already 
discussed. 

The  Operating  Statement.  We  now  have  all  the  figures  availa- 
ble for  our  operating  statement,  and  they  are  identical  with  those 
found  by  the  cost-accounting  method.  The  receipts  from  sales  are 
found  on  the  credit  side  of  Sales,  as  before,  the  detailed  costs  are 
found  on  the  ledger  and  in  the  consolidation  of  elements  of  cost, 
page  72,  and  the  distribution  of  these  costs  is  found  in  the  record 
of  transfer  of  these  consolidated  costs,  page  73. 

Comparison  of  Methods.  Though  our  ultimate  results  are  the 
same  in  the  two  cases,  we  must  not  fail  to  observe  the  difference  in 
the  working  of  the  two  methods.  The  inventory  method  depends 
so  much  upon  the  rare  accuracy  and  good  judgment  of  the  persons 
making  the  inventories  of  goods-in-process  that  we  may  say  it 
hinges  upon  them  —  and,  as  we  have  seen,  the  inventory  itself  is 
based  upon  the  very  costs  that  it  is  used  to  find;  whereas  the  cost- 
accounting  method  finds  costs  first  and  from  them  learns  invento- 
ries. The  inventory  method  requires  the  taking  of  inventories  as 
often  as  a  statement  is  desired,  and  as  taking  inventories  is  labor!- 


THE  OPERATING  STATEMENT  75 

ous  the  accounts  are  seldom  brought  to  the  current  period  and 
therefore  balance  sheets  are  infrequently  drawn  up;  whereas  by  the 
cost-accounting  method  balance  sheets  may  be  drawn  up  without 
the  labor  of  taking  account  of  stock.  Even  under  the  cost-account- 
ing method,  however,  it  is  necessary  occasionally  to  take  actual 
inventories  for  comparison  with  book  inventories,  for  only  so  can 
the  accuracy  of  the  book  figures  be  tested.  The  inventory  method 
finds  costs  only  in  totals,  and  only  at  the  end  of  each  period; 
whereas  the  other  method  finds  costs  of  specific  articles  and  finds 
them  currently.  The  inventory  method  can  find  profits  only  in 
totals,  and  only  at  the  end  of  each  period;  whereas  the  other  has  all 
the  figures  for  showing  the  profit  on  each  item,  and  can  record  it 
immediately  if  it  is  desired.  The  value  of  knowing  costs  and  profits 
or  losses  promptly  and  in  detail,  as  compared  with  knowing  them  in 
totals  (losses  hidden  behind  gains)  and  only  at  long  intervals,  needs 
no  conament.  The  fact  is,  however,  that  in  many  businesses  the 
inventory  method  is  the  only  one  feasible,  or  thought  to  be  feasible, 
and  hence  often  must  be  used. 

Converted  Assets  Accotmt.  It  is  interesting  now  to  go  back  to 
our  converted  assets  accoimt,  as  described  on  page  72,  and  see 
how  far  we  can  make  other  use  of  it.  We  have  seen  that  Con- 
verted Assets  may  be  debited  for  all  original  assets  or  costs  in- 
curred, irrespective  of  the  form  in  which  they  now  stand,  and  may 
be  credited  for  the  new  assets  resulting  from  the  conversion  of  the 
old,  irrespective  of  the  particular  assets  into  which  these  costs  were 
in  the  first  instance  converted.  In  other  words,  since  we  cannot 
under  this  incomplete  accounting  method  trace  costs  and  conver- 
sion item  by  item,  we  bring  all  items  of  costs  into  the  same  account 
with  the  items  representing  the  ultimate  form  which  those  costs 
have  taken  at  the  end  of  the  period.  Indeed,  we  learned  the  cost  of 
the  goods  sold,  for  comparison  with  selling  price,  by  seeing  how 
much  of  the  total  debit  to  Converted  Assets  was  not  accounted  for 
by  the  Goods-in-Process  and  Finished  Goods,  for  we  had  no  other 
way  of  finding  that  cost.  As  a  matter  of  fact,  however,  for  the 
purpose  of  finding  profits  we  do  not  need  to  show  the  selling  cost  on 
our  books  at  all,  but  can  go  direct  to  profits  if  we  wish.  We  have 
already  seen  that  at  the  time  sales  are  made  a  debit  is  made,  under 
the  inventory  method,  to  Cash,  or  Accounts  Receivable,  and  a 


76  THE  FUNDAMENTALS  OF  ACCOUNTING 

credit  is  made  to  Sold  Goods  or  Sales,  for  the  full  selling  price  —  a 
conversion  of  one  asset  into  another  at  an  increase  in  value.  The 
excess  of  credit  to  Sold  Goods  over  the  debit  to  Sold  Goods  is  pro- 
prietor's profit-claim.  Now  suppose  we  do  not,  though  we  did 
before,  make  any  debit  to  Sold  Goods  (crediting  Converted  Assets), 
for  the  cost  of  goods  sold,  but  transfer  to  Converted  Assets  at  the 
end  of  the  period  all  that  has  been  credited  to  Sold  Goods:  instead 
of  transferring  the  cost  of  sold  goods  from  Converted  Assets  to 
Sold  Goods,  we  transfer  the  yield  from  sold  goods  from  Sold 
Goods  to  Converted  Assets.  So  we  debit  Sold  Goods,  to  can- 
cel the  credits,  and  credit  Converted  Assets.  Converted  As- 
sets, as  we  have  already  seen,  is  already  credited  for  Goods-in- 
Process  and  Finished  Goods.  Converted  Assets  now  appears  as 
follows: 

Converted  Assets 

Goods-in-Process         2,205 
Finished  Goods  600 

Sold  Goods  1,700 


Raw  Material 

1,500 

Fuel 

100 

Insurance  Prepaid 

75 

Wages 

1,400 

Rent 

200 

General  Expenses 

4SO 

Royalties 

280 

(4,00s) 

(4,505) 

It  is  not  now  in  balance.  Apparently  more  assets  have  been  given 
up  than  acquired,  for  the  credits  exceed  the  debits.  We  know  this 
to  be  impossible,  and  therefore  it  is  obvious  that  our  books  have 
not  been  adjusted  to  the  full  facts.  The  unrecorded  fact  is  obvi- 
ously that  a  part  of  our  sales  were  not  mere  exchanges  of  assets 
dollar  for  dollar,  but  brought  more  value  to  us  than  they  took 
from  us,  and  hence  increased  proprietor's  ownership-claim.  We 
now  recognize  that  fact  on  the  books  by  transferring  from  Con- 
verted Assets  its  credit  balance  to  Proprietor's  Profit-Claim  — 
debiting  Converted  Assets  for  $500  to  get  the  amount  ofif  that 
account  and  crediting  Proprietor's  Profit-Claim.  We  have  thus 
the  same  result  as  by  the  cost-accounting  method.  We  have  not 
anywhere  on  the  books  clearly  designated  the  cost  of  goods  sold, 
to  be  sure,  but  we  can  get  it  for  the  purposes  of  the  operating 
statement  by  subtracting  from  the  total  debits  to  Converted  As- 
sets the  sum  of  Goods-in-Process  and  Finished  Goods  as  they  are 


THE  OPERATING  STATEMENT  77 

shown  above  ($4,005  —  $2,805  =  $1,200,  as  it  appears  on  the  oper- 
ating statement  on  page  64) .  If  there  had  been  a  loss,  the  debits 
to  Converted  Assets  would  have  exceeded  the  credits,  and  that 
difference  would  have  been  transferred  to  the  proprietor's  ac- 
count as  a  debit,  reducing  its  credit  balance. 

Profit  and  Loss  Account.  As  a  matter  of  fact,  in  many  busi- 
nesses it  is  common  to  keep  what  is  equivalent  to  this  converted 
assets  account  under  a  name  far  different,  namely,  Loss  and  Gain, 
or  Profit  and  Loss.  The  connection  between  the  titles  is  not  at 
first  glance  obvious,  and  the  significance  of  the  latter  accoimt  is 
often  unfortunately  lost  sight  of.  In  the  first  illustration  used  for 
Converted  Assets,  page  73,  it  is  obvious  that  there  is  neither  loss 
nor  gain,  for  all  costs  are  replaced  in  the  assets,  and  no  balance  is 
left  on  the  account.  The  effect  is  the  same  as  if  none  of  the  costs 
were  replaced  by  assets  but  were  thrown  away,  and  then  from  an 
entirely  different  source,  having  no  relation  to  the  costs,  new  assets 
sprang  into  being.  Indeed,  it  is  common  in  certain  types  of  busi- 
ness to  treat  all  costs  as  losses,  in  spite  of  the  fact  that  they  yield 
new  assets  by  conversion,  and  to  treat  all  returns  through  con- 
verted assets  as  gains.  That  is,  no  attempt  is  made  to  trace  each 
cause  to  its  effect,  but  costs  and  returns  are  treated  as  independent 
phenomena,  as  if  without  causal  connection  —  just  as  if,  to  use  an 
extreme  illustration  of  the  point,  the  things  bought  for  production 
purposes  and  all  the  money  spent  for  intangible  things  Hke  insur- 
ance had  been  thrown  into  the  sea,  and  then  a  lot  of  new  assets  of 
the  same  value  had  arrived  like  manna  from  heaven.  When,  how- 
ever, as  we  found  with  our  Converted  Assets  in  its  last  illustration, 
the  entries  are  not  merely  for  costs  but  for  both  costs  and  selling 
price,  page  76,  if  the  credits  (or  yield  from  conversions)  are  in 
excess  of  the  debits  (or  costs  of  conversions),  we  get  a  balance 
of  proprietor's  gain,  and  if  the  debits  are  in  excess  of  the  credits 
we  get  a  proprietor's  loss.  In  other  words,  this  Converted  Assets 
account  with  a  debit  balance  is  a  loss  account  (a  subdivision  of  pro- 
prietor's ownership-claim),  and  with  a  credit  balance  is  a  gain  ac- 
count, and  hence  it  may  well  be  called  Loss  and  Gain,  or  Profit  and 
Loss,  and  is  in  fact  commonly  so  called. 

Nominal  and  Real  Accounts.  So  far  no  mention  has  been  made, 
except  in  a  footnote,  of  so-called  "nominal"  and  "real"  accounts. 


78  THE  FUNDAMENTALS  OF  ACCOUNTING 

The  terms  "nominal"  and  "real"  are  almost  xmiversally  used  in 
books  on  accounting,  and  play  an  important  part  in  the  discussion. 
We  have  avoided  them  here,  because  they  are  confusing  to  novices. 
Since  the  terms  are  in  common  use  we  must  become  familiar 
with  them  and  their  content.  Roughly  we  may  say  that  a  real 
account  is  one  of  which  the  balance  represents  assets  or  owner- 
ship-claims recognizable,  at  the  time  the  balance  is  taken,  under 
the  name  used  in  the  title  of  the  account  —  as  cash  covered  by 
Cash,  merchandise  covered  by  Merchandise,  accounts  receivable 
covered  by  Accounts  Receivable,  accounts  payable  covered  by 
Accounts  Payable;  a  nominal  account,  on  the  other  hand,  is 
one  of  which  the  balance  does  not  at  the  time  the  balance  is 
taken  represent  assets  and  ownership-claims  recognizable  under 
the  name  used  in  the  title  of  the  account,  though  usually  the  ac- 
count has  previously  represented  some  such  asset  or  claim  which 
has  since  been  actually  converted  into  some  other  form  not  sug- 
gested by  the  title  of  the  account,  for  the  books  are  not  kept  up 
to  the  times  except  at  intervals  —  as  fuel  which  has  gone  into 
goods-in-process  or  finished  goods,  still  on  the  books  as  fuel,  or 
insurance,  still  on  the  books  as  insurance  though  actually  now  an 
integral  part  of  the  value  of  goods-in-process,  or  wages  paid,  still 
on  the  books  as  wages  though  the  cash  given  as  wages  has  actu- 
ally replaced  itself  in  the  goods  produced,  or  a  balance  on  the 
credit  side  of  Sold  Goods,  or  Sales,  which  represents  proprietor's 
gain. 

Distinction  between  Real  and  Nominal  Accounts.  It  will  be  seen 
that  the  difference  between  nominal  and  real  accounts  lies  in  this: 
if  the  name  of  the  account  indicates  the  thing  as  the  thing  now 
stands,  the  account  is  real;  if  the  thing  now  exists  not  in  the  form 
indicated  by  the  name  of  the  account  in  which  it  still  stands  but 
in  some  other  form,  as  goods-in-process  still  charged  to  Wages  or 
to  Rent,  or  proprietor's  profit-claim  still  credited  to  Sold  Goods, 
or  if  the  thing  does  not  exist  at  all  because  it  has  been  exhausted 
without  return,  or  if  it  has  been  converted  and  is  now  recorded 
under  its  new  name,  so  that  it  is  on  the  books  twice,  the  account 
is  nominal.  If  conversion  has  occurred  in  part  but  not  wholly, 
the  account  is  partly  real  and  partly  nominal.  Obviously  when 
the  books  are  prepared  for  the  balance  sheet,  care  must  be  taken 


THE  OPERATING  STATEMENT  79' 

that  adjustments  shall  be  made  in  all  accounts  requiring  adjust- 
ment, so  that  all  items  shall  be  covered  by  accounts  with  names 
that  suggest  the  actual  facts  at  the  date  of  the  balance  sheet. 
Since  a  balance  sheet  is  always  a  record  of  status  at  a  definite 
moment,  the  task  of  bringing  the  books  up  to  the  times,  and  thus 
preparing  them  for  the  balance  sheet  and  the  operating  statement, 
is  to  see  that  all  assets  and  ownership-claims  are  on  the  books  under 
accounts  with  names  that  properly  identify  them  and  with  amoimts 
that  properly  represent  them.  In  other  words,  balance  sheet  items 
are  real.  This  means  that  all  nominal  items  disappear,  must  dis- 
appear; for  the  very  essence  of  nominal  items  is  that  the  names  of 
accounts  no  longer  represent  the  facts.  Transfer  to  Converted 
Assets,  as  we  have  seen,  causes  them  to  disappear.  This  may  be 
put  in  another  way:  when  assets  and  ownership-claims  have  been 
taken  up  on  the  books  under  names  indicating  that  they  are  as- 
sets or  ownership-claims  (that  is,  in  real  accounts),  the  nominal 
accounts  lose  all  significance  as  representing  assets  and  owner- 
ship-claims and  become  purely  statistical,  and  the  net  balance  of 
all  nominal  accounts  (all  that  is  left  after  cancellations)  will  ex- 
actly equal  the  net  assets  or  ownership-claims  taken  up  on  the 
books  in  their  place:  for  assets  and  ownership-claims  cannot  be  on 
the  books  in  both  real  and  nominal  accounts  at  the  same  time, 
and  many  of  them  are  needed  in  statistical  form  during  the  oper- 
ating period,  for  guidance,  but  in  real  form  on  the  balance  sheet  at 
its  close. 

Mixed  Accounts.  When  an  account  represents  values  that 
have  been  wholly  converted  into  other  forms,  it  is  usually  called  a 
"pure  nominal"  account:  but  when  part  of  the  value  remains,  as 
with  Fuel  and  Insurance  in  our  illustrations  above,  it  is  com- 
monly called  "mixed"  —  the  part  which  has  been  consmned  is 
nominal,  and  the  part  remaining  as  an  asset  or  a  liability  is  real. 
We  kept  the  unconsumed  portions  on  our  books  under  their  old 
titles  and  showed  them  on  the  balance  sheet,  but  transferred  the 
consumed  portions  to  the  accoimts  representing  the  new  assets 
derived  from  the  old.  Wages,  Rent,  and  Royalty,  on  the  othe** 
hand,  were  pure  nominal  accounts,  and  so  nothing  of  them  re- 
mained on  the  books  or  went  to  the  balance  sheet  but  they  were 
wholly  transferred  as  costs  of  the  new  assets.    Hereafter  we  shall 


8o  THE  FUNDAMENTALS  OF  ACCOUNTING 

use  the  terms  "real  accounts,"  and  "nominal  accounts,"  and 
"mixed  accounts,"  with  the  meanings  attached  to  them  above, 
whenever  convenience  will  be  served  by  their  use. 

The  Use  of  Nominal  Accounts.  A  new  fact  should  now  be  ob- 
served: by  the  inventory  method  of  finding  profits  and  of  drawing 
up  operating  statements,  the  profit  or  loss  at  the  end  of  a  period 
can  be  found  directly  from  the  nominal  accounts  as  they  stand 
before  they  are  transferred  to  Converted  Assets  or  Profit  and 
Loss,  if  only  allowance  is  made  for  inventories.  It  will  now  be 
remembered  that  our  Converted  Assets  account  is  a  device  for 
gathering  our  nominal  accounts  so  that  we  may  find  the  net  re- 
sult of  the  transactions  relating  to  them  all,  which  is  our  profit  or 
loss.  On  the  debit  side  of  our  Converted  Assets  on  page  76  we 
gathered  all  the  items  of  costs  that  had  been  converted.  It  will 
be  remembered  that  of  the  original  Fuel  and  Insurance  Prepaid 
we  took  only  so  much  as  had  been  converted,  for  we  subtracted 
the  unconverted  portions,  or  present  inventories,  from  the  totals 
before  determining  the  amounts  to  be  transferred  to  Converted 
Assets,  that  is,  we  transferred  the  nominal  portions  only:  but  we 
could  not  subtract  the  inventories  of  goods-in-process  and  fin- 
ished goods  from  any  particular  costs,  for,  in  the  first  place,  they 
have  resulted  from  actual  conversion,  and,  in  the  second  place, 
we  do  not  know  of  what  particular  costs  these  inventories  are 
made  up;  so  in  making  entries  to  Converted  Assets  for  these  in- 
ventories we  made  allowance  not  by  deducting  from  the  debit 
side,  but  by  adding  to  the  credit  side  —  as  shown  by  the  credit 
items,  in  Converted  Assets,  for  Goods-in-Process  and  Finished 
Goods.  In  drawing  up  our  operating  statement,  however,  since 
these  two  items  have  not  yet  been  carried  through  the  sales  stage 
of  conversion  and  therefore  cannot  yet  show  a  profit,  they  are 
subtracted  from  costs  of  conversion  rather  than  added  to  yield 
from  conversion:  they  are  real  accounts,  cancelling  equal  value 
in  nominal  accounts.  We  may  now  list  our  nominal  items  as 
shown  below.  In  observing  them,  however,  we  should  remember 
that  all  the  items  except  the  two  inventories  (subtracted  because 
they  are  not  nominal)  actually  are  nominal,  and  then  observe 
that  they  are  identical  with  the  items  on  the  operating  statement 
on  page  64.  ~" 


THE  OPERATING  STATEMENT  8l 

$1,700 


Sold  Goods 

Raw  Material  consumed 

$1,500 

Wages 

1,400 

Rent 

200 

General  Expenses 

450 

Royalties 

280 

Fuel  consumed 

100 

Insurance  expired 

75 

Total 

$4,005 

Less 

Goods-in-Process 

$2,205 

Finished  Goods 

600 

2,805 

Net  nominal  debits 

$1,200 

Profit 

1,200 
$500 

One  way  of  finding  profits,  therefore,  is  simply  to  list  all  the  nomi- 
nal items,  debit  and  credit,  first  making  sure  that  all  necessary 
adjustments  have  been  made  to  carry  actual  present  assets  and 
ownership-claims  to  real  accounts,  and  then  find  the  difference. 
If  the  debits  exceed  the  credits,  the  result  is  a  decrease  in  pro- 
prietorship —  a  loss;  if  the  credits  are  in  excess  the  result  is  an 
increase  in  proprietorship  —  a  gain.  This  is  natural,  too,  for  prof- 
its and  losses  are  never  made  except  by  converting  things  —  as 
long  as  a  thing  is  unchanged  it  involves  no  gain  or  loss;  and  our 
nominal  accounts  represent  the  two  sides  of  our  conversions,  cost 
andyield ;  and  since  no  part  of  profit  or  loss  has  been  transferred  on 
the  books  during  the  year  from  the  nominal  accounts  to  the  pro- 
prietor's account,  all  profits  and  losses  are  still  in  the  nominal  ac- 
counts at  the  end  of  the  year  ready  for  the  final  entries  prepara- 
tory to  the  balance  sheet  and  the  operating  statement.  This, 
however,  is  only  another  way  of  saying  that  profit  or  loss  can  be 
found  from  the  converted  assets  account,  or  the  profit  and  loss 
account;  for  these  accounts  consist  under  the  inventory  method 
merely  of  the  items  transferred  from  nominal  accounts  in  the 
effort  to  clear  the  books  of  all  nominal  items  and  leave  only  real 
items,  or  assets  and  ownership-claims  under  properly  distinctive 
names,  on  the  books.  Other  illustrations  of  these  various  meth- 
ods, with  practice  in  their  use,  will  be  observed  in  connection  with 
detailed  bookkeeping  method  later. 


82 


THE  FUNDAMENTALS  OF  ACCOUNTING 


QUESTIONS  AND  PROBLEMS 

Show  the  fundamental  distinction  so  far  as  there  is  any  between  the 
cost-accounting  method  and  the  inventory  method  with  respect  to; 

(a)  finding  inventory  of  insurance 

(b)  finding  inventory  of  finished  goods 

(c)  statistical  information 

(d)  final  profit  on  sales 

Just  what  is  the  relationship  between  the  operating  statement  and  the 
converted  assets  account?  From  the  converted  assets  account  could 
you  construct  an  operating  statement?  From  the  following  figures, 
show  as  much  as  you  can  of  both  the  converted  assets  account  and  the 
operating  statement. 


At  begin- 

Debits 

At  end 

Credits 

ning  oj 

during 

oJ  year 

during 

year 

year 

year 

Raw  materials 

S,ooo 

12,000 

4,000 

Goods-in-process 

17,000 

15,000 

Finished  goods 

3,000 

6,000 

Wages 

8,000 

Insurance 

100 

Taxes 

300 

Rent 

1,000 

Sales 

30,000 

3.  The  following  balances  are  on  the  accounts  of  a  business. 


Debits 

Credits 

Proprietor 

$43,000 

Notes  Payable 

4,000 

Accounts  Payable 

10,000 

Real  Estate 

«4i,350 

Notes  Receivable 

6,400 

Cash 

1,516 

Fuel 

88 

Rent 

250 

Insurance  Prepaid 

249 

General  Expenses 

2,740 

Purchases  of  Merchandise 

64,550 

Sales 

67,167 

Interest 

740 

Commission 

236 

Accoimts  Receivable 

8,000 

$125,143        $125,143 

There  is  a  liability  for  general  expenses  amounting  to  $750.    Following 
are  the  inventories  at  the  end:  merchandise  $5,000,  mterest  receivable 


THE  OPERATING  STATEMENT 


83 


accrued  $30,  insurance  prepaid  $225.  Make  all  necessary  debits  and 
credits  preparatory  to  the  statements,  and  construct  the  operating 
statement  for  the  period  and  the  balance  sheet  at  its  close. 

4.  The  ledger  of  Jones  &  Smith,  who  are  equal  partners,  is  on  Janu- 
ary 31  as  follows: 


Real  Estate 

Equlpmknt 

100,000  1 

2,000  1 

Notes  Receivable 

Accounts  Receivable       Merchandise  Purchases 

20.000  1 

21,000  1 

7S,ooo| 

Merchandise  Sales 
1  46,500 

Cash 
28,000  1 

Insurance  Prepaid 
1,100  1 

Accounts  Payable 
1  10,000 

Notes  Payable 
132,000 

Interest 
260  1 

Wages 
300  1    . 

Taxes 

1,800  1 

Rent 
1  5,000 

Jones 
1  77,980 

Smith 
1  77,980 

Inventories  are  found  to  be 

Merchandise 
Insurance  Prepaid 

$3S,ooo 
850 

Wages  are  accrued  to  pay,  $150,  and  rent  is  accrued  in  their  favor, 

$500.    The  real  estate  has  depreciated  by  $2,000,  and  equipment  by 

$200. 

Make  entries  to  adjust  the  accounts  to  the  time,  using  a  loss  and  gain 

account.    Post  the  entries  to  the  ledger  and  draw  up  a  final  balance 

sheet.    [The  totals  of  the  balance  sheet  are  $205,150.] 

5.  Draw  up  an  operating  statement  for  Jones  &  Smith,  of  Problem  4. 

6.  Which  of  the  following  accounts  should  you  expect  to  be  real  and 
which  nominal  before  adjusting  the  accounts  to  the  time?    Why? 

Cash 

Wages 

Wages  Liability 

Interest 

Insurance  Prepaid 

General  Expenses 

Rent 

Notes  Payable 

Fuel 

Proprietor 

Real  Estate 

7.  Can  you  conceive  conditions  under  which  each  of  the  following  so- 
called  real  accounts  might  become  mixed  —  cash,  real  estate,  accounts 
receivable?    Explain. 


CHAPTER  VIII 

THE  CONTENT  OF  COMMON  ACCOUNTS 

Fixing  the  Content  of  Accounts.  Nothing  can  be  more  important 
in  accounting  than  a  realization  of  what  the  totals  and  balances  of 
various  accounts  stand  for.  Detailed  explanations  are  not  usu- 
ally shown  on  a  ledger,  and  could  not  be  shown  without  very- 
great  labor;  hence,  since  ledger  figures  must  be  taken  in  summary 
for  all  reports,  like  balance  sheets  and  income  sheets,  they  must 
be  classified  so  that  all  of  a  kind  can  be  placed  together  and  in- 
ferences can  be  drawn  both  from  their  totals  and  from  the  differ- 
ences between  contrary  totals.  Consequently  in  laying  out  a 
plan  for  ledger  accounts  careful  provision  must  be  made  that  all 
items  which  are  to  be  used  for  one  purpose  in  drawing  inferences 
be  carried  to  the  same  account,  and  that  no  other  items  be  carried 
thither.  The  titles  of  accounts  should  be  chosen  so  as  to  indicate 
at  a  glance  (or  as  nearly  so  as  is  feasible  without  unwieldiness) 
what  items  are  to  be  carried  to  them  —  that  is,  their  content. 
The  best  way  to  accomplish  this  is  to  fix  in  mind  certain  general 
types  of  content,  subdivide  these  in  accordance  with  the  informa- 
tion desired,  and  then  provide  an  account  for  each  subdivision. 
When  classified  information  is  required  in  great  detail,  many  ac- 
counts must  be  kept:  when  information  in  more  or  less  summary 
form  is  all  that  is  needed,  a  few  accounts  will  suffice. 

Groups  of  Accounts  Reviewed.  We  have  already  had  two 
classifications  of  accounts:  the  first  gives  us  asset  accounts  and 
ownership-claim  accounts,  both  of  which  appear  on  the  balance 
sheet;  the  second  gives  us  real  accounts,  which  include  both  asset 
accounts  and  ownership-claim  accounts,  and  nominal  accounts, 
which  do  not  appear  on  the  balance  sheet  but  furnish  information 
for  the  operating  statement.  Nominal  accounts,  as  we  have  seen, 
are  kept  primarily  for  statistical  purposes,  and,  though  they  rep- 
resent assets  or  ownership-claims  at  the  time  of  entry,  they  are 
not  kept  up  to  the  later  times  in  that  particular  but  accumulate 
statistical  information  which  may  or  may  not  at  any  moment 
represent  exactly  (or  at  all)  assets  or  ownership-claims  at  that 


THE  CONTENT  OF  COMMON  ACCOUNTS  85 

moment;  but  on  occasion,  as  necessity  or  convenience  dictates,  so 
much  of  these  statistical  accounts  as  represents  assets  or  owner- 
ship-claims is  transferred  to  real  accounts  and  thus  gets  upon  the 
balance  sheet.  The  only  part  of  nominal  accounts  that  does  not 
get  upon  the  balance  sheet,  therefore,  is  the  part  that  has  been 
cancelled  by  offsetting  items,  such  as  payment  of  wages  of  sales- 
men offset  in  the  selling  price  of  the  goods,  payment  of  office  rent 
offset  by  professional  charges  to  clients,  earnings  from  commission 
sales  offset  by  profits  drawn,  and  cost  of  fuel  offset  by  value  in- 
corporated in  goods-in-process  and  finished  goods;  so  that  the 
only  net  effect  at  the  time  of  the  balance  sheet  is  the  final  increase 
or  reduction  in  the  proprietorship  and  in  the  assets  or  liabilities 
which  are  the  accompaniments  of  it.  As  a  matter  of  fact,  few  ac- 
counts get  wholly  offset,  or  have  their  items  wholly  cancelled,  by 
other  accounts  in  any  operating  period.  Wages,  as  we  have  seen, 
is  a  good  illustration  of  a  nominal  account,  for  the  amount  charge- 
able to  it  is  almost  instantly  converted  into  assets  of  another  form 
(or  is  actual  loss  or  waste  and  thus  a  reduction  in  ownership- 
claims)  ;  but  not  usually  does  it  happen  that  the  wages  account 
is  offset  wholly  by  other  accounts  and  thus  disappears  without 
recognition  of  it  on  the  balance  sheet,  for  usually  some  wages 
have  been  earned  since  last  pay-day,  or  some  could  not  be  paid  on 
last  pay-day  (because  of  absence  or  illness),  or  some  have  been 
paid  in  advance.  Therefore  in  the  process  of  adjusting  for  the 
balance  sheet  certain  items  of  asset  or  of  ownership-claim  are 
likely  to  be  found  in  connection  with  nominal  accounts,  and  the 
name  of  the  nominal  account  is  likely  to  be  required  in  the  title  of 
the  balance-sheet  account  in  order  to  make  its  significance  clear  — 
as  Wages  Prepaid,  Wages  Liability.  This  is  true  of  virtually  all 
nominal  accounts.  We  may  say,  then,  that  if  we  discuss  ade- 
quately all  balance-sheet  accounts,  we  shall  in  the  process  discuss 
virtually  all  nominal  accounts  also.  The  only  kind  of  exception 
is  a  group  of  accounts  commonly  called  ''clearing  accounts," 
which  bring  together  parts  of  other  accounts  having  a  common 
relation,  and  these  show  the  net  result  of  that  common  relation 
and  transfer  that  net  result  to  another  account  or  accounts  that 
get  ultimately  on  the  balance  sheet  or  the  operating  statement. 
Such  is  Converted  Assets  used  in  the  preceding  chapter.    We  will 


86  THE  FUNDAMENTALS  OF  ACCOUNTING 

therefore  here  discuss  first  balance-sheet  accounts,  then  nominal 
accounts,  and  then  clearing  accounts. 

Other  Classifications.  For  various  purposes,  accounts  are 
often  classified  in  other  ways  than  those  mentioned  above.  Some 
of  these  classifications  merely  add  subdivisions  of  the  classes  given 
above,  and  some  add  entirely  new  groupings  (such  as  personal 
and  impersonal,  of  which  the  first  refers  to  accounts  with  persons, 
partnerships,  or  corporations,  and  the  second  to  accounts  of  all 
other  sorts).  The  difficulty  with  attempting  to  give  a  classified 
list  of  accounts  is  that  the  various  classifications  cross  one  an- 
other. For  example,  assets  are  divided  into  four  groups  with 
respect  to  availability  or  character  of  usefulness,  thus:  capital 
(those  which  are  not  expected  to  be  exhausted  with  one  use,  like 
buildings,  machinery,  etc.),  current  or  working  (necessary  to  day- 
by-day  conduct  of  business  and  expected  to  be  quickly  converted, 
like  cash,  supplies,  accounts  receivable),  deferred  or  prepaid  (like 
advance  payments  for  goods  to  be  delivered  later,  and  prepaid 
insurance),  and  accrued  (properly  belonging  to  the  business  but 
not  yet  due  and  not  yet  charged  to  the  persons  who  should  ulti- 
mately pay,  like  claims  for  interest  already  earned  but  not  yet 
demandable).  Assets  are  also  classified  on  the  entirely  different 
basis  of  external  character,  thus:  tangible  property  (in  which  the 
value  inheres  in  the  thing  itself,  like  real  estate,  cash,  supplies), 
intangible  property  (in  which  the  value  lies  in  certain  rights  and 
expected  return  from  those  rights,  like  copyrights,  patents,  and 
good  will),  and  claims  against  others  (of  which  some  may  be  evi- 
denced by  certain  tangible  documents  —  like  notes  receivable  and 
bonds,  the  value  lying  not  intrinsically  in  the  document  but  in  the 
claim  which  it  evidences  —  and  others  may  be  without  formal 
acknowledgment,  as  rent  accrued,  accounts  receivable,  commis- 
sion accrued).  To  classify  accounts  completely  would  require, 
for  example,  that  under  virtually  each  group  of  the  first  classifica- 
tion should  be  three  subdivisions  to  cover  the  three  groups  of  the 
second  classification.  In  the  following  discussion,  therefore,  no 
attempt  will  be  made  to  attach  to  each  account  the  various  labels 
that  might  be  applied,  as,  for  example,  *' impersonal,  accrued, 
claim"  to  sums  ultimately  collectible  but  not  yet  due  for  services 
in  selling  a  house  on  commission,  in  the  account  Commission  Ac- 


THE  CONTENT  OF  COMMON  ACCOUNTS       87 

crued.  In  each  case  such  description  will  be  given  of  the  usual 
content  of  the  account  that  its  place  in  any  scheme  of  classifica- 
tion should  be  evident.  The  general  plan  of  classification  for  the 
paragraphs  following  may  be  tabulated  briefly: 

Asset  Accounts  (The  discussion  will  include  such  comment  on 

each  as  will  make  clear  the  relation  between 
the  asset  account  and  the  operating  or  nominal 
accounts  with  which  it  is  naturally  connected) 

Contra  Accounts  (The  discussion  will  show  the  purpose  and  use 

of  certain  accounts  that  represent  deductions 
from  assets,  but  are  commonly  reported  on  the 
ownership-claim  side  of  the  balance  sheet  in 
spite  of  the  fact  that  they  do  not  represent 
claims  of  any  sort,  and  vice  versa) 

Ownership-Claim  Accounts  (treated  similarly  to  asset  accounts) 

Nominal  Accounts  (reviewing  the  nominal  accounts  already  dis- 
cussed in  connection  with  assets  and  owner- 
ship-claims, and  adding  such  further  discus- 
sion of  them  as  is  necessary  to  show  their 
content  and  treatment) 

Clearing  Accounts  (showing  their  relation  to  both  real  and  nomi- 

nal accounts) 

Accounts  primarily  for  corporations  are  not  discussed  here  but  in 
Chapter  XVI,  for  it  is  deemed  wise  for  the  reader  to  become  thor- 
oughly familiar  with  routine  matters  appHcable  to  virtually  all 
businesses  before  he  invites  confusion  by  studying  special  ac- 
counts. 

Flexibility  of  Ledger  Titles.  Inasmuch  as  the  names  we  have 
so  far  used  as  titles  of  accounts  have  been  chosen  largely  to  pro- 
vide clearness  of  exposition,  they  have  not  always  been  in  accord 
with  titles  commonly  used  in  business.  If  we  are  to  be  able  to 
interpret  financial  statements  of  businesses  other  than  our  own, 
we  must  know  the  common  titles  of  business  and  the  significance 
of  the  accounts  to  which  they  are  attached.  No  two  businesses 
can  ever  be  in  all  details  exactly  alike,  however.  Since  businesses 
depend  largely  for  policy  upon  accounting  information,  no  two 
businesses  can  have  identical  accounting  needs.  Careless  choice 
of  accounts  and  careless  handling  of  the  content  of  them  yield 
either  vague  or  misleading  statements,  and  sometimes  overem- 


88  THE  FUNDAMENTALS  OF  ACCOUNTING 

phasize  insignificant  facts  and  minimize  vital  facts.  Therefore 
the  selection  and  the  determination  of  the  content  of  accounts  is  a 
serious  matter  to  be  meticulously  performed  by  each  business  en- 
terprise; and  though  wide  departure  from  general  practice  in  the 
content  of  common  amounts  is  likely  to  lead  sooner  or  later  to 
misunderstanding,  details  and  titles  for  particular  needs  may  have 
great  flexibility.  No  attempt  is  made  here  to  cover  a  large  vari- 
ety of  alternatives  in  the  choice  of  titles  or  the  selection  of  content 
for  accounts.  Yet  certain  principles  of  classification  are  so  im- 
portant that  they  should  be  illustrated  with  the  greatest  care,  and 
when  the  best  illustrations  are  found  in  accounts  that  are  not 
altogether  common  such  accounts  are  used  for  illustration  here. 
In  the  pages  following,  for  example,  six  accounts  are  discussed 
for  interest  alone:  Interest  Accrued,  Interest  Prepaid,  Interest 
Earned,  Interest  Accrued  Liability,  Interest  Unearned,  Interest 
Charges;  each  has  its  importance  as  an  illustration  of  a  principle, 
its  use  in  actual  business,  and  its  place  on  a  balance  sheet  or  an 
income  sheet;  but  few  business  houses  would  keep  them  all  at 
once  or  make  entries  to  most  of  them  except  at  the  times  of  ad- 
justing the  books,  for  short-cut  methods  are  available.  Since  the 
short-cut  accounts  are  more  difficult  to  understand  than  the  ac- 
counts named  above,  however,  they  will  not  be  discussed  imtil 
Chapter  XIV,  where  they  will  show  again  the  flexibility  of  book- 
keeping methods. 

ASSET  ACCOUNTS 
The  Impermanence  of  Assets.  In  noting  a  statement  of  what 
an  account  is  meant  to  contain,  one  should  always  remember  that 
few  things  in  this  world  are  permanent  —  that  no  business  property 
remains  long  in  one  physical  condition  or  of  one  value.  The  mere 
lapse  of  time  causes  changes  in  condition  because  of  "wear  and 
tear,"  of  "moth  and  rust,"  of  weathering,  of  changes  of  fashion  or 
custom  which  affect  either  it  or  the  product  or  services  which  it 
helps  to  provide,  of  necessary  compensation  for  waiting  to  collect 
one's  dues.  Only  constant  entry  for  the  effect  of  these  changes,  as 
well  as  entry  for  transactions  with  other  people,  could  keep  ac- 
counts true  to  the  conditions  which  they  are  meant  to  record.  Any 
statement  about  the  content  of  an  account,  therefore,  is  subject  to 


THE  CONTENT  OF  COMMON  ACCOUNTS      89 

the  qualification  "when  brought  up  to  the  time."  This  applies  to 
the  discussion  following.  The  accounts  treated  imder  the  heads 
"asset  accounts"  and  "hability  accounts"  are  "real"  in  the  sense 
that  when  adjusted  for  the  balance  sheet  they  represent  assets  or 
ownership-claims  recognizable  under  the  name  used  in  the  title  of 
the  account,  but  at  all  other  times  certain  elements  of  them  are 
almost  sure  to  be  nominal,  that  is,  converted  to  other  forms  or  lost 
or  destroyed  altogether. 

Cash.  The  most  common  of  all  accounts  is  Cash.  It  is  debited 
for  all  receipts  of  money  (including  checks,  money  orders,  and  some- 
times sight  drafts),  and  is  credited  for  payments  of  the  same  sorts 
of  money;  hence  the  balance  represents  cash  available  for  use  (either 
on  hand  or  in  bank).  It  should  never  have  a  credit  balance,  of 
course.  If  no  error  has  been  made,  a  credit  balance  could  indicate 
only  an  overdraft  on  the  bank  account;  but  this  constitutes  a  loan 
from  the  bank  (if  the  check  is  honored,  and  it  is  not  a  payment  if 
the  check  is  not  honored),  and  should  be  entered  as  a  loan  from  the 
bank,  thus  increasing  the  cash  debits  and  correcting  the  credit 
balance.  In  one  respect  the  cash  account  is  unique :  it  stands  both 
for  value  and  for  quantity.  If,  for  example,  our  cash  balance  is 
$1,001  we  know  that  we  have  on  hand  one  thousand  one  dollars, 
worth  one  thousand  one  dollars.  Every  other  asset  account  ex- 
presses a  value  more  or  less  problematical,  for  all  accounts  are  ex- 
pressed in  dollars  and  yet  only  cash  is  actually  in  dollars;  the  other 
values  will  show  only  on  the  conversion  into  dollars,  and  hence  the 
dollars  attached  may  be  more  statistical  than  real. 

Petty  Cash.  It  is  customary  nowadays  to  make  as  many  pay- 
ments as  possible  by  check,  for  that  eliminates  the  risk  of  handling 
and  guarding  currency.  Some  expenditures,  however,  need  to  be 
made  in  currency,  either  because  of  their  pettiness  or  because  cur- 
rency is  preferred  by  the  person  to  whom  payment  is  made.  A 
petty-cash  fund  is  kept,  therefore,  out  of  which  such  payments 
may  be  made,  and  the  cash  is  recorded  in  an  account  called 
Petty  Cash.  The  handling  of  this  account  wiU  be  discussed  fully 
in  Chapter  XV. 

Merchandise — As  Inventory  Account.  On  the  balance  sheet 
Merchandise  indicates  owned  goods  on  hand  for  sale,  and  should 
never  include  any  other  sorts  of  purchases.    It  should  not  inchide 


90  THE  FUNDAMENTALS  OF  ACCOUNTING 

goods  held  by  the  business  to  be  sold  for  some  one  else  on  consign- 
ment, for  title  to  the  assets  does  not  then  vest  in  the  business  and 
the  assets  should  not  appear  on  its  balance  sheet.  Purchases  of 
raw  material  and  supplies  intended  for  manufacture,  even  though 
intended  for  ultimate  sale,  should  not  be  carried  in  this  account.  It 
may  include  goods  manufactured  by  the  business,  but  these  are 
preferably  carried  in  an  account  with  a  more  expressive  title,  like 
*^ Finished  Goods,"  or  "Manufactured  Goods"  —  especially  if 
the  business  also  sells  some  goods  that  it  buys  ready  for  sale.  The 
usual  rule  for  valuation  is  "cost  or  market,  whichever  is  lower." 
The  reason  for  this  is  discussed  on  page  285.  In  any  case  one 
should  realize  that  the  billed  price  or  quoted  price  is  often  not  the 
cost,  for  often  discounts  are  offered  for  early  payment  of  bills. 
The  natural  price  of  goods  is  the  price  after  all  offered  discounts 
have  been  deducted,  for  that  is  what  the  goods  can  be  bought  for. 
Whether  the  discounts  have  actually  been  taken  or  not,  the  amount 
of  offered  discount  should  be  deducted  from  the  gross  inventory; 
otherwise  the  business  with  inadequate  capital,  unable  to  take  its 
discounts,  will  have  the  highest  inventory  for  identical  goods,  and 
this  is  absurd. 

Merchandise  —  As  Mixed  Account.  In  counting  houses  in 
which  little  use  is  made  of  accoimts  except  for  occasional  knowledge 
of  assets,  of  Habilities,  and  of  profits.  Merchandise  is  carried  as  a 
mixed  account.  It  begins  the  period  with  a  debit  of  the  balance 
brought  over  from  the  period  before,  the  opening  inventory  men- 
tioned above.  Whenever  purchases  are  made  it  is  debited  at  cost, 
and  when  any  sales  are  made  it  is  credited  for  the  sale  price.  The 
balance  of  the  account,  then,  has  no  particular  significance;  for 
it  does  not  represent  merchandise  on  hand,  but  rather  merchandise 
on  hand  plus  or  minus  the  loss  or  profit  respectively  on  what  has 
already  been  sold.  If,  for  example,  we  begin  the  year  with  an  in- 
ventory of  $20,000,  buy  merchandise  for  $120,000,  and  make  sales 
of  some  of  that  merchandise  for  $130,000,  the  balance  on  the  ac- 
count is  $10,000.  It  may  happen  that  the  inventory  of  merchan- 
dise at  the  end  of  the  period  is  not  $10,000  but  $25,000.  In  that 
case,  what  we  sold  cost  only  $115,000,  and  the  transaction  yielded  a 
profit  of  $15,000,  as  shown  below  in  a  convenient  form  for  reporting 
such  items. 


THE  CONTENT  OF  COMMON  ACCOUNTS      91 

Sales  $i30»ooo 

Inventory  at  beginning  of  year  $  20,000 

Purchases  120,000 

Cost  of  goods  handled  $140,000 

Inventory  at  end  of  year  25,000 

Cost  of  goods  sold  115,000 

Gross  profit  on  sales  $15,000 

If  one  is  not  eager  for  statistical  information  about  one's  business, 
this  mixed  merchandise  account  will  serve,  for  it  produces  correct 
results;  but  if  some  sales  and  purchases  were  returned,  the  ledger 
could  not  distinguish  between  sales  and  returned  purchases,  for 
both  would  be  credited  to  Merchandise,  or  between  purchases  and 
returned  sales,  for  both  would  be  debited,  and  statistics  compiled 
from  the  accoimt  might  be  worse  than  useless.  For  this  reason  a 
better  way  is  to  cut  up  Merchandise  into  several  accounts  and  then 
combine  them  into  a  clearing  account,  as  will  be  discussed  on  page 
131 .  The  balance  which  it  shows  as  a  balance-sheet  or  as  a  mixed 
account  is  identical  with  the  figure  for  inventory  contained  in  it  as 
a  clearing  account.  The  method  of  handling  the  mixed  merchan- 
dise account  so  that  it  will  show  gross  profit  or  loss  on  the  ledger 
account  itself  is  discussed  in  Chapter  XIV. 

Shipments.  When  we  ship  goods  out  to  be  sold  on  commission, 
we  hold  the  consignee  responsible  for  the  care  of  the  property, 
but  he  is  not  responsible  for  its  money  value  —  that  is,  he  is  not 
actually  in  debt  to  us.  So  when  goods  are  shipped  a  debit  should 
be  made  not  to  Accounts  Receivable,  but  to  a  shipment  account 
for  all  the  costs  of  the  shipment  —  with  a  credit  to  merchandise 
for  the  cost  of  the  goods  shipped,  to  cash-  for  cash  expenses  in- 
curred, etc.  The  total  debits  then  represent  costs  incurred  for 
goods  shipped  for  sale  on  consignment.  Then  when  the  com- 
mission agent  reports  the  goods  sold,  a  credit  is  made  to  the 
shipment  account,  with  a  debit  to  Accounts  Receivable  or  Cash. 
The  balance  on  the  shipment  account  when  all  the  goods  have 
been  sold  is  the  gain  or  loss. 

Notes  Receivable.  When  formal  acknowledgment  of  early- 
maturing  debt  is  desired,  a  promissory  note  is  requested  or  a 
draft  is  drawn.  Since  both  notes  and  drafts  are  negotiable,  the 
possession  of  such  formal  acknowledgment  enables  one  to  realize 


92  THE  FUNDAMENTALS  OF  ACCOUNTING 

on  claims  without  waiting  for  their  maturity,  for  they  can  be  sold. 
They  should  therefore  be  carried  in  an  account  separate  from  other 
claims.  The  possessor  carries  them  in  Notes  Receivable,  or  Bills 
Receivable.  Notes  are  promises  to  pay  and  drafts  are  orders 
to  pay;  but  when  drafts  are  accepted  they  become  also  promises 
to  pay.  The  distinction  between  them,  and  the  details  of  trans- 
actions with  them,  are  matters  of  business  routine  and  not  of  ac- 
counting; but  they  must  be  understood  by  any  one  who  is  to 
handle  the  accounts  for  them.^  When  notes  or  drafts  which  con- 
stitute claims  against  others  are  received,  Notes  Receivable,  or 
Bills  Receivable,  is  debited;  when  such  notes  or  drafts  are  paid,  in 
whole  or  in  part,  the  part  paid  is  credited  to  this  account.  If  a 
draft  ordering  some  one  else  to  pay  us  is  sent  to  us,  and  the  drawee 
accepts  it,  we  debit  Notes  Receivable  and  credit  the  sender;  if  the 
drawee  refuses  to  accept  it,  it  is  waste  paper  and  no  entry  is  in- 
volved. If  we  draw  a  draft  in  our  own  favor  and  the  drawee  ac- 
cepts it,  we  debit  Notes  Receivable  and  credit  the  drawee.  If  he 
does  not  accept  it,  we  need  no  entry.  Drafts  that  we  draw  on 
others  in  favor  of  third  parties  are  not  Notes  Receivable  to  us,  for 
they  are  not  collectible  by  us.  If  they  are  accepted,  we  debit 
the  payee  and  credit  the  drawee.  Drafts  that  we  accept  are 
treated  under  Notes  Payable.  Care  must  be  taken  not  to  include 
inadvertently  in  this  account  things  which  it  is  not  meant  to 
cover.  Though  it  is  often  called  ''Bills  Receivable,"  from  the 
fact  that  the  title  originated  in  the  days  when  drafts  were  called 
** bills'*  in  this  country  as  in  England,  it  is  not  usually  meant  to 
cover  sums  receivable  on  bills  for  merchandise  sold  on  charge 
account  unless  a  promissory  note  or  draft  is  given.  It  is  not  conir 
monly  intended  to  cover  interest  on  interest-bearing  notes  or 
drafts,  but  "face"  only.  One  objection  to  incorporating  in  this 
account  the  interest  accrued  is  that  the  amount  of  interest  is 
daily  changing,  of  course,  and  identification  of  an  entry  with  the 
note  is  difficult  when  the  entry  does  not  tally  with  any  figure  ap- 
pearing on  the  note  itself;  hence  the  face  only,  or  that  portion  of 
the  face  which  is  paid,  is^carried  to  this  account,  and  the  accrued 
interest  is  carried  to  an  account  provided  specifically  for  interest. 

*  For  the  assistance  of  those  not  familiar  with  financial  documents  a  brief  discus- 
sion of  drafts  will  be  foimd  'm  Appendix  A,  page  411. 


THE  CONTENT  OF  COMMON  ACCOUNTS      93 

Notes  Receivable  Discounted.^  In  the  paragraph  above  we 
observed  that  Notes  Receivable  is  credited  when  notes  or  drafts 
are  paid.  This  is  not  the  same  as  saying  that  the  account  is 
credited  when  the  notes  or  drafts  are  sold;  for  we  do  not  by  selling 
a  note  or  draft  make  sure  that  we  get  our  money  and  pass  on  to 
the  buyer  the  risk  of  failure  to  collect  what  it  calls  for.  When 
such  an  instrument  is  sold,  the  seller  endorses  it,  and  that  endorse- 
ment guarantees  its  collectibility  (that  is,  binds  the  endorser  to 
pay  if  the  maker  or  acceptor  fails  to  pay).  This  constitutes  a 
liability  —  contingent,  to  be  sure,  but  so  often  and  so  unfortu- 
nately serious  that  because  of  it  many  firms  have  gone  into  bank- 
ruptcy with  heavy  loss  to  their  creditors.  The  books  do  not  tell 
the  truth  if  they  neglect  it.  When  a  note  or  draft  is  disposed  of 
(other  than  by  payment),  therefore,  the  credit  should  be  not  to 
Notes  Receivable  as  if  we  had  sold  the  note  without  guarantee, 
but  to  an  account  which  will  show  the  contingent  liability.  This 
leaves  Notes  Receivable  untouched,  and  for  a  reason.  We  have 
no  longer  the  note  or  draft  in  our  possession,  but  it  may  come 
back  into  our  possession;  that  is,  it  is  an  asset  to  us  contingent  in 
just  the  same  degree  of  probable  reality  that  the  liability  on  the 
endorsement  is  contingent.  If  we  must  pay  the  amount  called 
for  by  the  note,  we  will  get  back  the  note.  The  contingent  asset 
and  the  contingent  liability  are  equal.  If  we  meet  the  note  when 
due,  it  will  be  because  we  got  the  money  for  it  in  advance,  and 
we  shall  be  no  worse  oQ  than  if  we  had  kept  it  from  the  begin- 
ning—  we  shall  be  merely  returning  what  we  borrowed  (plus 
interest,  of  course) .  So  at  the  time  of  selling  a  note  or  draft  (com- 
monly called  *' discounting"),  one  should  debit  Cash  and  credit 
Notes  Receivable  Discounted.  If  then  the  payer  fails  to  pay,  the 
seller  meets  his  liability  with  cash,  and  reverses  the  entry  for  the 
borrowing:  he  debits  Notes  Receivable  Discounted  and  credits 
Cash.  Things  are  then  as  they  were  before  (neglecting,  for  the 
moment,  interest) :  that  is,  the  note  is  in  hand  and  is  included  in 
Notes  Receivable  as  it  has  been  all  along.  If,  on  the  other  hand, 
the  payer  of  the  note  pays  it  at  maturity,  both  the  seller's  con- 

*  It  will  be  observed  that  this  is  not  an  asset  but  a  liability  account.  It  is  so  closely 
tied  up  with  Notes  Receivable,  however,  representing  temporarily  a  substitute  for 
credits  to  that  account,  that  it  cannot  be  discussed  independently,  and  is  conse- 
quently placed  here. 


94  THE  FUNDAMENTALS  OF  ACCOUNTING 

tingent  liability  and  his  contingent  claim  on  the  note  are  ended  and 
they  should  no  longer  stand  on  the  books.  He  will  now  debit 
Notes  Receivable  Discounted  and  credit  Notes  Receivable,  thus 
removing  both.  He  will  know  that  his  liability  has  ended,  for 
under  the  law  of  endorsement  an  endorser  is  released  from  Hability 
if  he  is  not  immediately  notified,  by  formal  "notice  of  protest," 
of  the  failure  of  the  maker  of  a  note  to  pay.  So  if  he  hears  no 
word  after  a  reasonable  time  for  notification,  he  knows  that  either 
the  note  was  paid  or  his  liability  has  ended  by  lapse. 

Notes  Receivable  Doubtful.  When  notes  and  drafts  previously 
discounted  have  been  taken  up,  because  of  liability  on  endorse- 
ment, they  are  presumably  of  doubtful  value  —  else  the  payers 
would  not  have  defaulted  in  payment.  Since  this  puts  them  at 
once  into  a  different  category  from  notes  which  have  not  yet  be- 
come due,  it  is  well  to  transfer  them  from  Notes  Receivable  to 
Notes  Receivable  Doubtful.  This  is  accomplished  by  crediting 
the  former  and  debiting  the  latter  as  soon  as  the  notes  are  taken 
up,  that  is,  at  the  same  time  with  the  entry  debiting  Notes  Re- 
ceivable Discounted  and  crediting  Cash.  If  such  notes  are  finally 
paid,  Notes  Receivable  Doubtful  will  be  credited.  If  not  paid, 
the  amount  will  be  charged  to  Losses  from  Bad  Debts  and  cred- 
ited to  this  account.  Endorsed  notes  which  have  not  been  sold 
or  discounted,  if  they  prove  uncollectible,  will  be  protested  by  the 
business,  of  course  (so  as  to  hold  the  endorsers  liable).  They 
should  similarly  be  transferred  to  this  account.  Notes  without 
endorsers,  too,  when  proved  uncollectible  should  be  transferred 
to  this  account  unless  hope  of  collecting  them  is  at  once  aban- 
doned, in  which  case  they  should  be  written  off  and  a  debit  should 
be  made  to  Loss  from  Bad  Debts. 

Mortgage  Notes  Receivable.  When  a  note  is  secured  by  the 
pledge  of  real  estate,  so  that  if  the  note  is  not  paid  the  property 
may  be  taken  and  sold  to  supply  the  necessary  money  for  pay- 
ment, the  notes  may  be  carried  in  a  special  account  for  that  pur- 
pose. It  is  desirable  to  carry  them  in  such  an  account,  for  usu- 
ally such  notes  have  a  long  term,  perhaps  several  years,  and 
hence  are  not  so  quickly  converted  (unless  by  sale)  as  ordinary 
commercial  notes  and  drafts.  The  mortgage  itself  does  not  need 
recording  on  the  books  of  the  holder  in  any  account,  for  it  is 


THE  CONTENT  OF  COMMON  ACCOUNTS      95 

wholly  contingent  and  the  contingency  is  sufficiently  indicated 
in  the  title  of  Mortgage  Notes  Receivable.  If,  on  the  other  hand, 
the  mortgage  is  foreclosed  and  the  property  is  taken,  the  property 
must  be  entered,  of  course.  This  may  involve  trust  accoimts,  which 
we  need  not  discuss  here. 

Accounts  Receivable.  Accounts  Receivable  is  usually  intended 
to  cover  claims  to  payment  for  merchandise  only.  When  goods 
are  sold  on  account.  Accounts  Receivable  is  debited  for  the 
amount  of  the  sale;  and  when  payment  is  made,  the  account  is 
credited.  If  a  note  or  a  draft  is  given  as  acknowledgment  of  the 
debt,  the  account  is  paid;  that  is,  though  the  debt  remains,  it  is 
now  registered  in  another  account,  Notes  Receivable,  and  should 
be  cancelled  here.  The  entry  debits  Notes  Receivable  and  credits 
Accounts  Receivable.  As  a  matter  of  fact,  all  accoimts  receivable 
are  indexed  under  customers'  names,  as  we  shall  see  later,  and  all 
sales  items  which  we  wish  indexed  should  go  through  this  account 
for  record.  So  if  we  wish  the  account  to  give  us  maximum  in- 
formation we  may  enter  to  Accounts  Receivable  not  only  amoimts 
due  on  account,  but  certain  sales  to  customers  for  goods  which 
they  immediately  pay  for  in  cash,  though,  of  course,  we  must 
credit  the  accounts  also  for  the  payments.  Otherwise  we  shall 
not  have  indexed  record  of  those  to  whom  we  make  cash  sales, 
perhaps  our  best  customers,  and  hence  those  with  whom  we  wish 
to  stimulate  sales.  Commonly  the  amount  shown  as  a  balance  on 
Accounts  Receivable  is  an  overstatement  of  the  amount  actually 
receivable,  for  in  many  businesses  discounts  are  offered  for  early 
payment  of  bills  and  such  discounts  are  widely  taken.  The  ac- 
coimting  method  of  showing  recognition  of  this  fact  is  discussed 
in  connection  with  contra  accounts  later  in  this  chapter.  When 
such  discounts  are  given  Accounts  Receivable  is  credited  for  them 
as  well  as  for  the  cash,  for  the  amount  is  no  longer  an  asset.  Ac- 
counts may  be  opened,  similar  to  Accounts  Receivable,  for 
amoimts  owed  for  services.  Such  an  account  may  be  called 
"Receivable  from  Clients,"  or  merely  "Clients." 

Accounts  Receivable  Doubtful.  A  credit  manager  watches  with 
great  care  the  collection  of  accounts  receivable,  and  to  facilitate 
this  often  wishes  to  segregate  accounts  receivable  which  have  run 
for  a  specified  time  or  for  any  one  of  many  reasons  are  deemed 


96  THE  FUNDAMENTALS  OF  ACCOUNTING 

of  doubtful  collectibility.  Such  an  account  is  Accounts  Receiv- 
able Doubtful.  To  shift  an  item  from  Accounts  Receivable  to 
Accounts  Receivable  Doubtful,  the  latter  is  debited  and  the  for- 
mer is  credited.  If  a  doubtful  account  is  finally  given  up  as  bad, 
Accounts  Receivable  Doubtful  is  credited  and  Losses  from  Bad 
Debts  is  debited.  If  the  account  is  paid  after  it  has  been  written 
off  as  bad,  justice  to  the  customer  requires  that  the  account  be 
put  back  on  Accounts  Receivable,  whence  it  was  originally  taken, 
so  that  there  the  record  may  show  that  it  was  finally  paid. 

Goods-in-Process.  As  we  have  already  found  in  Chapter  VI, 
all  the  costs  of  manufacturing  goods  for  sale  can  be  carried  through 
Goods-in-Process.  This  account,  however,  unlike  those  just  dis- 
cussed in  this  chapter,  does  not  have  entries  made  to  it  whenever 
any  change  takes  place  in  the  status  of  what  it  represents,  for 
changes  in  goods-in-process  take  place  in  any  large  factory  not 
only  every  minute  but  in  a  hundred  places  at  once.  It  is  debited 
for  the  costs  that  have  gone  into  the  product;  but  those  debits  are 
made  only  at  convenient  or  necessary  intervals.  It  follows,  there- 
fore, that  except  when  the  books  have  been  adjusted  for  the  bal- 
ance sheet,  the  debits  to  this  account  may  or  may  not  represent 
all  the  costs.  The  account  is  credited,  as  we  saw  in  Chapter  VI, 
for  the  cost  of  finished  goods  sent  from  the  shop  or  factory  to  the 
warehouse  or  salesrooms.  When  the  account  is  adjusted  —  that 
is,  is  complete  to  the  time  —  its  balance  represents  the  cost  of 
goods  at  present  in  the  shop  or  factory  uncompleted,  that  is, 
the  manufactured  cost  of  their  uncompleted  state.  In  Chapter 
XXII  we  shall  see  briefly  how  these  figures  are  obtained.  We 
shall  see  also  later  in  this  chapter  that  Goods-in-Process  is  a  clear- 
ing account,  and  that  the  balance  which  it  shows  as  a  balance- 
sheet  account  is  derived  from  it  as  a  clearing  account. 

Raw  MateriaL  To  Raw  Material  go  all  purchases  of  principal 
materials  for  manufacturing.  By  the  cost-accounting  method, 
when  materials  are  requisitioned  for  immediate  use  in  manufac- 
turing, this  account  is  credited  and  Goods-in-Process  is  debited 
for  the  cost  of  what  is  requisitioned;  the  balance  of  the  account 
indicates  the  cost  of  raw  material  in  the  storeroom.  Separate 
records  should  be  kept  for  receipts  and  issues  of  each  t)^e  of  raw 
material,  so  that  quantities  bought,  consumed,  and  on  hand,  may 


THE  CONTENT  OF  COMMON  ACCOUNTS      97 

be  watched.  The  sum  of  the  balances  of  each  kind  should  equal 
the  balance  of  the  general  account.  Physical  count  should  be 
taken  at  convenient  intervals  (preferably  when  the  stock  of  each 
kind  of  material  is  low)  in  order  to  make  sure  that  error  has  not 
been  made  and  loss  by  waste  or  theft  has  not  been  suffered.  When 
purchases  have  been  made  at  different  prices  and  a  new  purchase 
is  made  before  the  old  stock  is  exhausted,  it  is  customary  to  issue 
at  each  purchase  price  in  turn  imtil  as  many  have  been  issued  at 
each  price  as  were  purchased  at  that  price  —  so  that  both  the 
oldest  supply  and  the  oldest  price  are  utilized  in  full  before  a 
new  supply  and  a  new  price  are  drawn  upon.  By  the  inventory 
method,  no  credits  are  made  currently  to  Raw  Material  (except, 
of  course,  for  materials  returned  or  diverted  to  other  uses  than 
manufacturing),  but  at  the  end  of  the  period  the  inventory  is 
taken  and  the  difference  between  the  net  debits  (inventory  at  the 
beginning,  plus  purchases,  minus  returns  or  diversions)  and  the 
inventory  at  the  end  is  the  assumed  consumption  in  manufac- 
turing (though  it  may  include  quantities  lost  track  of,  lost  by 
breakage  and  waste,  and  lost  by  theft).  When  this  is  credited  to 
this  account  and  debited  to  Goods-in-Process  or  its  substitute,  the 
balance  is  the  inventory  for  the  balance  sheet;  or,  if  we  prefer  to 
put  it  this  way,  we  may  say  that  when  the  inventory  at  the  end  is 
credited  to  this  account,  the  balance  is  the  consumption  to  be 
transferred  to  Goods-in-Process.  To  this  account  is  sometimes 
carried  freight  and  cartage  on  purchases,  but  these  are  preferably 
first  carried  to  a  special  account,  for  statistical  record,  and  then 
transferred  to  this  account  or  to  Goods-in-Process. 
r  Supplies.  In  general.  Supplies  is  intended  to  cover  articles 
destined  for  quick  use  and  expected  to  be  consumed  in  that  use. 
Sometimes  the  articles  are  akin  to  raw  materials,  as  auxiHary  ma- 
terials, and  are  expected  to  go  into  manufactured  goods,  as  eyelets 
in  a  shoe  factory  and  ink  in  a  printing  establishment.  In  that 
case  they  should  have  a  separate  account,  as  Material  Supplies,  or 
even  stand  in  individual  accounts.  Similarly  we  may  have  Office 
SuppUes,  Janitor  Supplies,  Power-House  Supplies,  Storeroom 
Supphes,  Salesroom  Supplies.  In  a  large  business,  supplies  may 
cost  many  thousand  dollars  a  year,  and  as  they  are  peculiarly 
subject  to  carelessness  and  waste  by  irresponsible  employees,  they 


98  THE  FUNDAMENTALS  OF  ACCOUNTING 

should  be  watched  carefully;  this  sometimes  involves  a  separate 
account  for  each  variety  of  supplies.  Many  kinds  of  supplies, 
though  often  not  thought  of  as  supplies,  are  commonly  so  treated. 
Among  accounts  for  these  are  Fuel,  Postage,  Stationery  and  Print- 
ing, and  Wrapping  Paper  and  Twine.  By  the  cost-accounting 
method,  Supplies  should  be  credited  for  consumption;  and  the 
accounts  representing  the  values  into  which  supplies  have  been 
converted  (like  Goods-in-Process,  Finished  ,Goods,  Sold  Goods) 
should  be  debited;  but  this  would  involve  so  much  detailed  record 
keeping  that  it  is  virtually  never  done  except  for  manufacturing 
suppHes,  and  the  inventory  method  is  used.  Either  of  two  ways 
of  looking  at  the  account  may  be  adopted,  for  they  come  to  the 
same  thing  in  the  end:  all  debits  to  Supphes  may  be  thought  of 
as  representing  assets,  or  balance-sheet  items,  but  needing  ad- 
justment at  the  end  of  the  period  for  consumed  supplies,  which  is 
provided  by  debiting  Goods-in-Process,  Sold  Goods,  Converted 
Assets,  or  what  not,  and  crediting  this  account;  or  all  debits  may 
be  thought  of  as  costs  or  losses,  depletions  of  proprietorship,  but 
adjustable  at  the  end  of  the  period  for  unconsumed  items,  the  in- 
ventory. The  latter  is  the  commoner  method,  and  treats  all 
supply  accounts  as  nominal. 

Furniture  and  Fixtixres.  No  uniformity  of  practice  is  found 
in  names  applied  to  accounts  representing  assets  intended  for  long- 
continued  use,  over  several  earning  periods.  In  manufacturing 
establishments,  Furniture  and  Fixtures  usually  covers  office  fur- 
niture, such  as  desks,  safes,  tables,  chairs,  cabinets,  etc.,  but  no 
manufacturing  equipment.  In  mercantile  establishments,  it  may 
include  counters,  show  cases,  show-window  attachments,  etc.  — 
i.e.,  selling  as  well  as  office  facilities.  In  good  accounting,  dis- 
tinction should  be  made  between  things  which  serve  office  pur- 
poses and  those  which  serve  manufacturing  or  selling  purposes. 
It  may  be  worth  while,  therefore,  to  subdivide  this  account  ac- 
cording to  the  kinds  of  service  rendered.  In  any  case,  the  account 
is  debited  for  purchases,  and  is  credited  for  depreciation,^  for 
abandonment  of  worn-out  furniture  and  fixtures,  for  recoveries 
of  insurance  on  property  destroyed,  and  for  sales  (in  no  case  at 
more  than  the  value  at  which  the  property  concerned  stands  on 
^  A  substitute  for  this  credit  is  discussed  on  page  107. 


THE  CONTENT  OF  COMMON  ACCOUNTS  99 

the  books  at  the  time).  The  balance  of  the  account  when  it  has 
been  adjusted  to  the  time  is  the  balance-sheet  item. 

Equipment.  When  mechanical  facilities  are  provided  for  any 
part  of  a  business  other  than  manufacturing,  their  value  is  usually 
carried  in  Equipment.  Such  are  typewriters,  adding  machines, 
and  dictating  machines,  in  an  office,  shoe-repair  machines  in  a 
shoe  store,  scales  and  trucks  in  a  storeroom,  and  horses  and 
wagons  or  motor  trucks  in  the  deUvery  department.  Sometimes, 
however,  this  account  overlaps  what  we  have  treated  above  as  in 
Furniture  and  Fixtures  and  below  as  in  Machinery.  The  account 
is  debited  for  purchases  and  is  credited  for  depreciation,^  for 
abandonment,  and  for  sales,  similarly  to  Furniture  and  Fixtures. 

Machinery.  Tools,  machine  tools,  and  machines,  are  com- 
monly carried  together  in  one  account.  Machinery,  though  it  is 
well  to  separate  them  because  of  the  different  inevitable  rates  of 
depreciation  to  which  they  are  subject.  Belting,  shafting,  pul- 
leys, etc.,  are  often  included  in  this  account,  though  properly  they 
should  be  carried  separately.  The  account  is  handled  similarly 
to  Furniture  and  Fixtures,  and  to  Equipment;  because  of  the 
common  magnitude  of  the  values  involved,  however,  the  proper 
handling  of  depreciation  is  even  more  important.  Depreciation 
forms  the  subject  of  Chapter  XVIII. 

Power  Plant.  Since  the  production  of  power  is  a  function 
which,  though  connected  with  machinery,  may  often  be  operated 
independently  (to  run  other  machinery  than  that  for  which  it 
was  primarily  installed),  and  since  power  may  often  be  engaged 
from  outside  sources  of  supply,  accounts  should  make  possible  the 
determination  of  costs  of  power.  This  involves  a  knowledge  of 
what  is  tied  up  in  power  plant.  So  the  equipment  of  the  power 
plant  should  be  carried  in  a  separate  account.  Power  Plant,  or  in 
two  accounts.  Engines,  and  Boilers.  It  is  treated  similarly  to  the 
account  just  discussed. 

Plant.  When  various  kinds  of  permanent  facilities  are  not  dif- 
ferentiated but  are  carried  in  one  general  account,  Plant  serves 
this  purpose.  Sometimes  even  further  consolidation  takes  place, 
and  we  find  Real  Estate  and  Plant  as  one  account. 

Real  Estate.  Since  real  estate  consists  of  land  and  buildings, 
^  A  substitute  for  this  credit  is  discussed  on  page  107. 


lOO  THE  FUNDAMENTALS  OF  ACCOUNTING 

with  their  appurtenances,  and  of  nothing  else,  it  properly  should 
be  carried  in  an  account  distinct  from  all  others;  for  the  economic 
laws  affecting  values,  including  those  of  depreciation  and  appre- 
ciation, affect  this  field  somewhat  differently  from  others.  Some- 
times land  and  buildings  are  carried  separately  from  each  other: 
land  may  appreciate  while  the  buildings  depreciate.  Usually  a 
separate  account  is  kept  for  each  parcel  of  real  estate.  Real 
Estate  is  debited  for  purchases  at  cost  and  is  credited  for  depre- 
ciation,^ for  recoveries  of  insurance  on  property  destroyed,  and 
for  sales.  Care  must  be  taken,  however,  when  sales  are  made, 
that  credit  is  not  given  to  this  account  for  more  than  the  amount 
at  which  the  property  sold  stands  on  the  books  at  the  time  of  sale; 
for,  if  this  is  done,  the  balance  of  the  account,  which  is  supposed 
to  represent  the  value  of  what  remains,  will  be  reduced  errone- 
ously by  the  amount  of  the  profit:  if  one-half  of  property  on  the 
books  at  $50,000  is  sold  for  $30,000,  the  profit  is  $5,000,  and  the 
balance  of  real  estate  is  $25,000;  but  if  the  sale  is  credited  to  Real 
Estate  at  $30,000,  the  balance  of  the  account  will  be  only  $20,000. 
The  correct  entry  will  credit  Real  Estate  only  $25,000  and  pro- 
prietorship $5,000  —  in  some  account  to  be  discussed  in  Chapter 
XVII. 

Bonds  Owned.  Since  bonds,  which  are  in  principle  only  in- 
terest-bearing notes  of  corporations,  are  more  formal  than  notes, 
are  better  protected  from  forgery  and  counterfeit,  run  usually  for 
longer  terms,  and  are  commonly  more  readily  salable  (because 
their  value  is  better  known  through  the  publication  of  market 
sales),  they  should  be  carried  in  a  separate  account.  Since  the 
face  values  are  of  standard  varieties  (usually  multiples  of  $100), 
and  the  price  paid  for  bonds  bought  is  likely  to  be  either  more  or 
less  than  the  face  (for  reasons  to  be  discussed  later),  it  is  usual 
to  debit  Bonds  for  the  price  paid  rather  than  for  the  par  or  face 
value.  The  account  is  credited  for  sales  at  the  book  value  of  the 
bonds  sold  (as  described  for  real  estate  above).  The  detailed 
handling  of  the  bond  account  involves  interesting  mathematics 
that  need  more  discussion  than  can  be  given  in  this  chapter,  and 
will  be  found,  in  connection  with  other  similar  and  important 
things,  in  Chapter  XXI.  Sufficient  for  our  pmrposes  here  is  a 
*  A  substitute  for  this  credit  is  discussed  on  pt^ge  107. 


THE  CONTENT  OF  COMMON  ACCOUNTS      lOI 

realization  that  the  debit  balance  on  Bonds  is  supposed  to  repre- 
sent the  bonds  of  other  companies  held  by  the  business  on  whose 
books  the  account  appears.  Since  the  value  of  each  bond  is  de- 
pendent on  many  circumstances,  some  of  which  hinge  upon  the 
circumstances  of  the  company  issuing  them  and  some  on  the  text 
of  the  bonds  themselves  (e.g.,  whether  they  car cy; mortgage  prc^r 
vision  or  not),  each  issue  of  bonds  should  stand  in  an^accoimt  by 
itself.  ...     ...   rt.  :.  ^ 

Stocks  Owned.  Stock  in  other  businesses  often  forms  an  appre- 
ciable part  of  the  assets  of  an  enterprise.  Corporations,  as  we 
shall  see  later,  are  owned  not  by  individuals,  as  are  partnerships 
and  single  proprietorships,  but  by  stockholders  who  do  not  exer- 
cise direct  individual  control.  These  stockholders  hold  certifi- 
cates of  stock  which  entitle  them  to  the  distributed  profits  of  the 
corporation  and  to  the  distributed  assets  in  case  of  dissolution. 
Valuable  stock  is  therefore  a  source  of  earnings,  like  real  estate, 
machinery,  and  bonds,  and  represents  actual  assets  in  the  custody 
of  the  company  issuing  the  stock  certificates;  and  if  the  company 
issuing  the  stock  is  well  known,  the  certificates  have  an  easily 
ascertainable  market  price.  Usually  a  separate  accoimt  is  kept 
for  each  kind  of  stock  owned;  for  the  values  of  stocks  vary  widely, 
even  with  the  same  par  or  face  value,  because  of  varying  circum- 
stances connected  with  each.  The  account  for  each  is  debited  for 
the  cost  of  stock  bought,  and  should  be  credited  for  each  sale  at 
the  book  figure  at  the  time  of  sale.  Any  gain  should  be  credited 
to  proprietorship  in  an  appropriate  account  to  be  discussed  in 
Chapter  XVII.  If  the  owner  of  the  stock  is  itself  a  corporation,  it 
should  not  include  in  Stocks  Owned  any  stock  issued  by  itself,  but 
should  carry  such  stock  in  Treasury  Stock  or  some  other  account 
discussed  in  Chapter  XVI. 

Funds.  Oftentimes  property  is  set  aside  for  a  special  purpose, 
and  is  represented  in  a  fund  account.  Funds  may  consist  of 
bonds  and  stocks,  or  of  cash,  for  example.  If  a  business  has  a 
large  expenditure  to  make  at  some  future  time,  it  may  provide  a 
fund  out  of  which  ultimately  the  payment  will  be  made.  Many 
bonds  are  paid  out  of  such  a  fund,  called  a  * '  sinking  f und.'*  Each 
year  during  the  life  of  the  bonds  the  fund  is  increased,  and  at  the 
time  of  maturity  it  may  be  large  enough  to  repay  the  money  bor- 


102  THE  FUNDAMENTALS  OF  ACCOUNTING 

rowed  on  the  bonds.  The  term  "fund"  should  not  be  carelessly 
used:  it  is  preferably  used  only  for  property  set  aside  for  a  special 
purpose.  A  fund  account  is  debited  for  property  put  into  the 
fund  and  credited  for  property  taken  out.  It  is  well  to  show  by 
the  title  of  the  account  the  nature  of  the  property  in  the  fund,  as 
with  Sinkijig  Fund  Cash,  or  Sinking  Fund  Bonds. 
' '  Interfest  Accrued.  A  number  of  common  business  transactions 
iife' recurrent  or  even  continuous  in  their  nature,  rather  than  oc- 
casional, and  require,  as  we  have  seen,  special  provision.  Interest 
given  as  compensation  for  the  use  of  money  is  an  illustration.  It 
is  always  determined  by  applying  a  rate  or  percentage  to  a  prin- 
cipal sum  for  the  time  of  the  loan;  and  so  it  is  constant  and  un- 
varying day  by  day  as  long  as  the  terms  of  the  loan  remain  un- 
changed, even  though  it  may  be  paid  only  on  occasion  —  at  the 
beginning  of  the  term  of  borrowing,  at  the  end,  or  occasionally 
during  the  term.  Both  the  status  of  the  business,  as  shown  by  the 
balance  sheet,  and  the  earnings  and  expenses,  as  shown  by  the  op- 
erating statement,  are  affected  by  the  accrual  of  interest  whether 
the  interest  has  actually  been  paid  or  not.  If  we  lend  $i,ooo  on 
December  i6  at  6%,  on  December  31  accrued  interest  to  the 
amount  of  $2.50  will  have  accrued  in  our  favor, ^  even  though  the 
loan  may  run  six  months  and  interest  on  it  may  not  be  due  or  be 
paid  until  the  debt  matures.  Our  claim  to  that  amount  is  an  as- 
set; and  if  we  adjust  our  books  to  that  day  we  may  debit  Interest 
Accrued  and  credit  Interest  Earned  (a  subdivision  of  proprietor's 
gain).  It  should  be  noted  that  Interest  Accrued  represents  the 
asset,  and  Interest  Earned  represents  the  ownership  of  that  asset. 
When  the  interest  accrued  is  paid.  Interest  Accrued  is  credited 
and  Cash  is  debited,  of  course.  By  the  time  payment  is  made, 
however,  more  interest  is  likely  to  have  accrued.  For  this  accrual 
another  entry  may  be  made;  or,  to  save  labor,  the  new  accrual 
may  be  omitted,  and  when  Cash  is  debited  a  credit  may  be  made 
to  Interest  Accrued  for  the  portion  already  entered  and  to  Inter- 
est Earned  for  the  new  portion.  Thus  we  get  both  the  asset  at 
the  time  of  the  balance  sheet  and  the  measure  of  interest  earned 
for  the  period.  Interest  accrued  is  constantly  growing  larger 
until  paid.  Interest  accrued  is  not  always  earned,  however:  it 
^  Information  about  interest  is  given  in  Appendix  B. 


THE  CONTENT  OF  COMMON  ACCOUNTS  IO3 

may  be  bought.  If  we  buy  a  bond  on  June  i  that  bears  interest 
payable  January  i  and  July  i,  we  buy  five  months'  accrued  inter- 
est, and  we  must  debit  Interest  Accrued  and  credit  Cash.  Then 
of  the  interest  payment  on  July  i  only  the  interest  for  June  will 
be  earned.  On  July  i  we  can  debit  Interest  Accrued  and  credit 
Interest  Earned  for  the  June  interest,  and  then  debit  Cash  and 
credit  Interest  Accrued  for  the  six  months'  interest;  or  we  can 
debit  Cash  for  the  six  months'  interest,  and  credit  Interest  Ac- 
crued for  the  five  months'  interest  and  Interest  Earned  for  the 
June  interest.  Statistically  the  former  is  better,  and  more  sys- 
tematic, but  the  latter  is  shorter  —  if  one  does  not  forget  what 
is  what  and  make  a  blunder. 

Interest  Prepaid.  Akin  to  Interest  Accrued,  though  in  some 
senses  reversed,  is  Interest  Prepaid.  This  account  represents  not 
an  asset  to  come  in  as  (presumably)  cash,  but  a  right  or  privilege 
for  which  (presumably)  cash  has  gone  out.  Whereas  interest 
accrued  grows  constantly  larger  until  paid,  interest  prepaid  grows 
constantly  smaller  until  expired.  The  asset  which  it  represents  is 
the  right  to  use  other  people's  money  temporarily  in  our  enter- 
prises, and  the  fact  that  we  are  willing  to  pay  for  the  use  of  the 
money  shows  that  we  deemed  that  right  to  have  value  —  else 
why  should  we  have  given  a  perfectly  good  asset,  cash,  in  ex- 
change for  it?  Indeed,  even  if  we  make  foolish  use  of  the  bor- 
rowed money  and  earn  nothing  with  it,  that  fact  does  not  destroy 
the  right  as  an  asset;  for  the  right  which  we  have  paid  for  is  to  use 
the  money,  and  such  right  has  a  universally  recognized  market 
value,  and  to  squander  that  privilege  later  is  a  loss  of  the  later 
period  but  cannot  work  retroactively  and  destroy  the  value  of  the 
right  in  itself  at  the  time  when  it  was  prepaid.  Prepaid  interest 
is  of  two  sorts  —  that  which  is  paid  in  advance  and  in  addition  to 
the  amoimt  written  in  the  face  of  the  note,  draft,  or  other  evi- 
dence of  debt,  and  that  which  is  deducted  from  the  face  of  the 
note,  or  other  evidence  of  debt,  and  never  loaned.  The  last  is 
called  discount,  but  is  identical  in  nature  with  interest  and  is  car- 
ried in  the  same  account.  If  a  note  for  $1,000  does  not  bear  in- 
terest and  is  due  two  months  from  to-day,  our  bank  will  give  us 
for  it  if  we  discount  it  not  $1,000,  but  $1,000  less  the  interest  (at 
say  6%)  on  $1,000  for  two  months,  or  $990.    We  are  in  effect, 


I04  THE  FUNDAMENTALS  OF  ACCOUNTING 

then,  paying  interest  in  advance,  $io  for  the  use  of  $990  for  two 
months.  Our  entry  will  be  properly  a  debit  to  Cash  for  $990,  to 
Interest  Prepaid  for  $10,  and  a  credit  to  Notes  Receivable  Dis- 
counted (or  Notes  Payable  if  the  note  is  one  of  our  own  mak- 
ing) for  $1,000.  As  time  goes  by,  the  prepayment  expires,  and 
whereas  it  was  $10  at  the  beginning,  at  the  end  of  one  month  it  is 
only  $5.  This  expiration  is  of  course  the  result  of  conversion  of 
assets;  and  Interest  Charges  (one  statistical  subdivision  of  Con- 
verted Assets,  or  Goods-in-Process,  or  Loss  and  Gain)  is  debited 
and  Interest  Prepaid  is  credited. 

Rent  Accrued.  When  rent  has  accrued  in  favor  of  a  business  at 
the  time  of  a  balance  sheet,  it  must  show  as  Rent  Accrued.  At 
the  time  of  debiting  this  account,  Rental  Earned  (a  subdivision  of 
proprietor's  gain)  is  credited.  When  rent  previously  entered  as 
Rent  Accrued  is  paid,  this  account  is  credited;  but  when  rents 
not  debited  to  this  account  are  paid,  this  accoimt  is  not  needed, 
unless  for  statistical  completeness,  for  the  entry  is  simply  a  debit 
to  Cash  and  a  credit  to  Rental  Earned. 

Rent  Prepaid.  We  have  just  seen  that  Rent  Accrued  is  han- 
dled similarly  to  Interest  Accrued,  with  Rental  Earned  allied  to  it 
and  to  Interest  Earned.  The  same  parallelism  applies  to  Rent 
Prepaid  and  Interest  Prepaid,  and  to  Rental  Charges  and  Literest 
Charges. 

Commission  Accrued.  When  one  business  sells  goods  on  be- 
half of  another  it  is  given  usually  a  percentage  of  the  selling  price 
as  compensation.  If  such  compensation  has  been  earned  but  not 
received,  it  should  appear  on  the  balance  sheet  as  Commission 
Accrued.  The  credit  is  to  Commission  Earned.  When  commis- 
sion entered  as  Commission  Accrued  is  paid,  this  account  is  cred- 
ited; but  payment  made  to  the  business  without  previous  entry 
of  accrual  is  credited  directly  to  Commission  Earned. 

Insurance  Prepaid.  Lisurance  is  usually  paid  in  advance  for  a 
term  longer  than  a  single  earning  period,  and  therefore  when  paid 
it  is  usually  debited  to  Insurance  Prepaid.  As  it  expires  this  ac- 
count is  credited  and  Insurance  Charges  (a  subdivision  of  Con- 
verted Assets,  or  Loss  and  Gain)  is  debited. 

Wages  Prepaid.  The  account  for  prepaid  wages  is  akin  to  the 
other  accounts  for  prepayments.    As  the  prepayments  expire,  the 


THE  CONTENT  OF  COMMON  ACCOUNTS  I05 

account  is  credited,  and  Wages  (a  subdivision  of  Converted  As- 
sets, Goods-in-Process,  Loss  and  Gain,  or  whatever  the  case  may 
indicate)  is  debited. 

Other  Accrued  and  Prepaid  Assets.  Other  kinds  of  things 
than  those  mentioned  above  may  be  accrued  or  prepaid,  and  the 
accounting  will  be  similar  to  that  described  above.  At  entry  for 
accrual,  bringing  the  books  up  to  the  time,  the  account  for  the 
accrued  asset  will  be  debited  and  the  appropriate  earning  account 
will  be  credited.  At  payment,  the  portion  of  the  earning  which 
has  already  been  entered  as  accrued  is  credited  to  the  accrual 
account,  and  the  rest  is  credited  directly  to  the  earning  account; 
or  the  new  accrual  may  also  be  entered  to  the  accrual  account, 
crediting  the  earning  account,  and  then  the  cash  payment  will  be 
credited  to  the  accrual  account.  Prepayments  are  given  reverse 
treatment.  When  payment  is  made,  the  prepayment  account  is 
debited;  as  time  passes  and  adjustment  becomes  necessary,  the 
prepayment  account  is  credited  and  the  account  representing  the 
conversion  (or  loss  if  the  prepayment  is  wasted)  is  debited.  Great 
caution  must  be  exercised  in  determining  what  has  been  or  re- 
mains still  prepaid,  for  any  exaggeration  means  false  security  and 
overstatement  of  profits.  An  extended  advertising  campaign, 
for  example,  may  have  its  effect  over  several  earning  periods,  and 
a  large  part  of  the  cost  of  the  advertising  may  be  deemed  unex- 
hausted at  the  time  the  balance  sheet  is  taken:  in  that  case, 
though  it  is  intangible,  many  would  carry  it  in  Prepaid  Adver- 
tising. Unless  one  is  sure  of  one's  ground,  however,  conserva- 
tism frowns  on  this.  It  is  easy  to  name  advertising  campaigns 
that,  though  of  comparatively  short  duration,  had  effect  in  in- 
creasing sales  over  many  years;  but  this  is  after  the  event:  it 
was  not  necessarily  wise  to  assume  in  the  beginning  that  the  cam- 
paign would  continue  to  yield  results  after  expenditure  should 
stop. 

Rights.  Often  assets  consist  largely  not  of  things  or  of  claims 
to  things  that  are,  but  of  claims  to  things  that  are  to  be.  Patent 
rights  are  a  good  illustration.  They  enable  the  owner  of  a 
patent  to  control  the  sale  of  an  article,  and  therefore  to  fix  its 
price  or  even  prevent  its  manufacture.  If  by  such  control  he  can 
insure  higher  profits  than  without  it,  the  possession  of  the  right  is 


Io6  THE  FUNDAMENTALS  OF  ACCOUNTING 

a  source  of  income  and  an  asset.  What  is  paid  for  the  right  (the 
cost  of  obtaining  the  patent,  or  its  purchase  price  if  bought  from 
another)  is  accordingly  debited  to  Patent  Rights.  Good  account- 
ing practice,  for  reasons  to  be  given  later,  does  not  sanction  debit- 
ing the  account  for  more  than  cost.  The  account  is  credited  for 
shrinkages  in  value  —  from  gradual  expiration  of  the  patent, 
from  decline  of  earning  from  it,  or  from  discovery  of  overvalua- 
tion ;  and  conservatism  is  the  part  of  wisdom.  The  mathematical 
method  of  finding  the  value  of  a  patent  is  discussed  in  Chapter 
XXI.  Similar  to  patent  rights  are  copyrights,  leaseholds,  trade- 
marks, royalty  rights,  franchises,  and  good  will.  They  will  be 
discussed  more  fully  in  Chapter  XXI. 

Suspense  Accounts.  Occasionally  it  happens  that  a  business 
cannot  at  once  determine  the  disposition  of  some  property  ac- 
quired and  dislikes  to  give  it  even  temporarily  a  wrong  name;  yet 
it  is  desirable  for  the  acquisition  to  be  in  some  way  recorded  on 
the  books.  For  this  purpose  Suspense  Account,  designating  un- 
certain disposition,  is  serviceable.  This  may  occur  on  tentative 
balance  sheets,  but,  when  possible,  final  disposition  should  be  de- 
termined and  entered  before  final  balance  sheets  are  prepared.  A 
qualifying  term  may  well  be  added  to  the  title  of  the  account,  as 
in  Real  Estate  Suspense.  Such  an  account  is  often  used  also  for 
doubtful  receivables,  both  notes  and  book  accounts. 

Contingent  Assets.  It  is  not  uncommon  in  business  to  surren- 
der property  to  another  as  a  pledge  for  the  performance  of  an  act. 
Resumption  of  such  property  is  contingent  on  the  performance  of 
the  act,  for  in  case  of  failure  of  performance  the  property  is  sub- 
ject to  forfeiture.  It  is  important  that  contingent  items  be  dis- 
tinguished from  others  to  which  title  is  clear;  for  otherwise  we 
may  think  that  we  have  available  more  property  than  we  actually 
have,  or  we  may  not  in  formulating  our  policy  sufficiently  recog- 
nize the  possibility  of  forfeiture.  Among  such  contingent  assets 
are  notes  receivable  already  discounted,  as  mentioned  on  page 
93;  but  in  that  case  the  contingency  is  indicated  by  the  liability 
account  rather  than  by  the  asset  account.  Another  example  is 
cash  deposited  with  a  city  treasurer  by  a  contractor  as  a  pledge 
for  fulfillment  of  his  contract  to  build  a  bridge  within  a  certain 
time,  covered  by  Cash  Deposited  as  Pledge  on  Contracts. 


THE  CONTENT  OF  COMMON  ACCOUNTS     IO7 

CONTRA  ACCOUNTS 
Allowance  for  Depreciation.  In  connection  with  several  asset 
accounts  we  noted  that  depreciation  of  the  property  required  a 
reduction  of  the  value  as  shown  by  the  books.  Statistically  this 
may  or  may  not  be  advantageous.  Sometimes  we  are  concerned 
not  only  with  the  present  value,  or  the  portion  of  original  cost  still 
remaining,  but  with  the  actual  original  cost,  and  we  wish  that 
original  cost  to  remain  on  our  books  without  change.  We  at  the 
same  time  wish  to  show  the  exhaustion  of  that  value  by  use  or 
discontinuance.  Both  purposes  can  be  served  by  estabHshing  a 
new  account  to  measure  the  exhaustion  of  original  value,  and  by 
remembering  that  the  story  of  the  property  is  now  told  in  two 
accounts  instead  of  one  and  that  the  remaining  value  lies  in  the 
difference  between  the  two  accounts.  Such  an  account  is  Allow- 
ance for  Depreciation  of  Buildings  (sometimes  called  Reserve 
for  Depreciation  of  Buildings).  This  Allowance  for  Deprecia- 
tion of  Buildings,  though  it  has  a  credit  balance,  does  not  repre- 
sent an  ownership- claim,  but  merely  measures  the  overvaluation 
of  assets.  To  use  a  homely  figure  of  speech,  the  asset  account 
may  be  said  to  measure  the  diameter  of  a  doughnut,  and  the  al- 
lowance account  to  measure  the  diameter  of  the  hole;  so  that  the 
substance  of  the  doughnut  is  indicated  by  the  difference  between 
the  two.  An  allowance  account  measures  a  hole  in  an  asset  when 
for  statistical  reasons  we  desire  to  show  both  the  original  whole 
and  the  present  hole.  Suppose  a  piece  of  real  estate  cost  $40,000 
a  year  ago,  and  we  wish  now  to  show  depreciation  for  the  year 
amounting  to  $1,000.  We  may  debit  Depreciation  $1,000  and 
credit  Real  Estate  $1,000,  leaving  Real  Estate  at  $39,000  and 
carrying  $1,000  from  Depreciation  to  Converted  Assets;  or  we 
may  debit  Depreciation  $1,000  as  before  and  credit  Allowance  for 
Depreciation  of  Buildings  $1,000,  in  which  case  we  shall  have 
not  only  $40,000  for  Real  Estate  on  the  balance  sheet,  but  also  an 
item  of  Allowance  for  Depreciation  of  Buildings  $1,000  on  the 
other  side  of  our  balance  sheet  (as  if  it  were  an  ownership-claim). 
The  title  of  the  allowance  account,  however,  makes  clear  that  it  is 
neither  a  liability  nor  a  proprietorship  item,  but  merely  a  deduc- 
tion (or  negative)  for  an  item  on  the  other  side  of  the  sheet.    By 


I08  THE  FUNDAMENTALS  OF  ACCOUNTING 

this  method  we  avoid  all  danger  of  burying  beyond  resurrection 
(through  various  depreciation  entries)  the  actual  cost  of  the  prop- 
erty, an  important  historical  fact.  The  only  danger  is  that  some 
one  will  observe  the  $40,000  for  real  estate  on  the  balance  sheet 
or  on  the  books  and,  failing  to  see  the  $1,000  Allowance  for  De- 
preciation of  Buildings,  be  deceived.  On  the  balance  sheet  the 
danger  of  this  is  sometimes  avoided  by  showing  the  $1,000  allow- 
ance as  a  subtraction  from  the  real  estate  item  of  $40,000,  thus: 

Real  Estate  $40,000 

Less  Allowance  for  Depreciation  1,000 

$39,000 

This  cannot  be  done  on  the  ledger,  for  to  do  so  would  be  to  destroy 
just  what  we  are  trying  to  preserve;  but  persons  unfamiliar  with 
accounts  should  not  try  to  interpret  ledgers.  Similar  allowance 
accounts  can  be  provided  for  depreciation  of  machinery,  of  equip- 
ment, and  of  any  other  kind  of  property  subject  to  depreciation. 
The  ultimate  disposition  of  the  allowance  account  is  discussed  in 
Chapter  XVIII. 

Allowance  for  Bad  Debts.  Akin  in  nature,  but  somewhat  dif- 
ferent in  detail,  is  Allowance  for  Bad  Debts  (sometimes  called 
Reserve  for  Bad  Debts).  Few  businesses  escape  without  occa- 
sional losses  from  uncollectible  items.  These  losses,  however,  be- 
long properly  not  to  the  period  in  which  the  badness  of  the  debts 
is  discovered,  but  to  the  period  in  which  the  debts  were  incurred. 
This  means  that  at  the  end  of  any  earning  period  allowance  must 
be  made  for  the  uncoUectibility  of  accounts  and  notes  receivable. 
So  far  as  the  amounts  are  not  yet  due,  we  do  not  know  how 
many  are  bad,  or  which  are  bad.  We  know  only  that  in  all  prob- 
abiHty  a  certain  percentage  (estimated  from  general  experience) 
will  ultimately  prove  bad,  and  one  of  the  costs  of  making  the 
sales  (or,  better,  of  collecting  what  we  do  collect  on  the  good 
sales)  is  the  risk  we  take  and  loss  we  suffer  on  the  bad  sales.  The 
risk  we  take  is  one  of  the  things  that  produces  sales  and  profits, 
and  hence  the  losses,  which  are  the  measure  of  the  risk,  constitute 
one  of  the  elements  that  we  have  put  into  sales  (like  cost  of  goods, 
selling  wages,  etc.)  and  must  be  counted  as  among  the  converted 
assets,  returned  in  the  price  of  goods  successfully  sold.    We  must. 


THE  CONTENT  OF  COMMON  ACCOUNTS     109 

then,  carry  the  loss  ultimately  as  a  debit  to  Converted  Assets  (or 
Sold  Goods,  or  Loss  and  Gain,  as  we  choose)  and  show  also  the 
shrinkage  in  assets.  Here,  however,  we  cannot,  as  we  could  with 
depreciation  of  real  estate  and  other  tangible  property,  credit  the 
asset  account  directly  for  the  shrinkage,  for  we  do  not  know  which 
individual  accounts  receivable  will  prove  bad;  and  we  do  not 
wish  to  write  off  the  account  on  the  ledger  until  we  write  off  also 
the  individual  items  of  which  it  is  made  up,  for  the  two  should 
tally.  So  here  we  are  forced  to  credit  Allowance  for  Bad  Debts 
rather  than  to  credit  the  asset  account  itself.  The  complemen- 
tary debit,  which  is  of  course  ultimately  to  be  transferred  to  Con- 
verted Assets,  or  Loss  and  Gain,  or  some  similar  account,  will  be 
discussed  in  connection  with  nominal  accounts  later  in  this  chap- 
ter. The  credit  to  Allowance  for  Bad  Debts  is  usually  sufficient 
to  put  the  latter  account  on  the  books  at  a  predetermined  per- 
centage of  the  amount  of  accounts  receivable  and  notes  receiva- 
ble. This  is  the  measure  of  the  overvaluation  —  or  hole  in  the 
assets.  When  accounts  receivable  of  a  former  period  are  f oimd  to 
be  bad.  Accounts  Receivable  is  credited  (to  show  shrinkage  of  the 
asset),  and  Allowance  for  Bad  Debts  is  debited;  now  things  are  as 
they  should  be,  for  the  loss  was  in  the  year  of  sale  and  was  charged 
as  a  loss  in  that  year  through  the  debit  that  was  made  when  the 
allowance  was  credited,  and  the  debit  now  made  to  Allowance  for 
Bad  Debts  and  credit  to  Accounts  Receivable  is  merely  to  shift 
the  record  of  shrinkage  from  the  indefinite  allowance  account 
(representing  an  estimated  shrinkage  in  unknown  specific  items) 
to  the  definite  asset  account  (representing  specific  sums  demand- 
able  from  specific  people).  Careful  attention  to  this  allowance 
account  must  be  given,  of  course,  else  it  will  be  too  small  and 
profits  will  be  overstated,  or  it  will  be  too  large  and  assets  will  be 
hidden;  but  it  contains  in  itself  the  information  necessary  for  cor- 
rection of  it  when  in  error.  If,  for  example,  all  the  bills  of  the 
preceding  period  have  been  either  paid  or  written  off  and  a  credit 
balance  remains  on  this  account,  it  is  obvious  that  the  allowance 
at  the  end  of  the  first  period  is  excessive,  for  at  the  end  of  the 
second  period  no  debts  of  the  first  period  remain  to  become  bad 
and  to  absorb  it.  If,  on  the  other  hand,  the  old  bills  still  unpaid 
are  largely  in  excess  of  the  balance  and  are  of  very  doubtful  col- 


no  THE  FUNDAMENTALS  OF  ACCOUNTING 

lectibility,  the  allowance  is  probably  deficient,  and  better  provi- 
sion should  be  made  in  the  future. 

Allowance  for  Discount  Offered.  It  is  common  in  many  lines 
of  business  to  offer  a  reduction  in  the  amount  of  a  bill  if  it  is  paid 
early  —  e.g.,  3%  if  paid  within  10  days,  2%  if  paid  within  30 
days,  and  net  (regular)  terms  60  days.  These  are  called  ''cash 
discounts."  Though  this  is  a  concession  to  the  customer,  it  has 
some  advantage  to  the  seller:  he  gets  his  pay  sooner  and  can  thus 
turn  over  his  capital  more  rapidly  and  save  interest,  and  he  gets 
rid  of  so  much  risk  of  loss  by  failure  to  collect  (to  trust  a  customer 
sixty  days  means  just  six  times  the  risk,  other  things  being  equal, 
involved  in  trusting  him  ten  days).  The  latter  is  the  reason  why 
cash  discount  rates  are  so  much  higher  than  interest  rates.  A 
rate  of  3%  discount  for  payment  in  10  days,  as  contrasted  with  a 
payment  net  in  60  days,  is  3%  for  payment  50  days  early,  or  at 
the  rate  of  approximately  22%  a  year.  So  far  as  payments  are 
early,  less  than  the  face  of  bills  will  be  received  on  accounts  re- 
ceivable, and  hence  if  they  are  put  on  the  balance  sheet  with- 
out provision  for  discounts  assets  and  profits  will  be  overstated. 
Yet  we  cannot  well  reduce  the  figure  on  the  ledger,  for  we  do  not 
know  which  customers  will  take  their  discounts  offered,  and  we 
wish  our  ledger  account  to  tally  with  the  total  of  the  individual 
items  recorded  as  receivable.  We  accordingly  set  up  an  allow- 
ance account  to  show  the  overvaluation  of  accounts  receivable, 
crediting  Allowance  for  Discounts.  The  complementary  debit  is 
ultimately  transferred  to  Converted  Assets,  or  Loss  and  Gain,  or 
other  similar  account,  and  will  be  discussed  later  in  this  chapter 
in  connection  with  discounts.  In  the  subsequent  period  Allow- 
ance for  Discount  Offered  will  be  debited  for  actual  discounts 
given  on  old  bills.  The  complementary  credit  will  be  to  Accounts 
Receivable;  thus  Accounts  Receivable  is  credited  for  the  discount 
portion  of  old  bills  paid,  along  with  the  credit  for  the  cash  por- 
tion of  such  bills. 

Allowance  for  Discount  Available.  The  converse  of  Allowance 
for  Discount  Offered  is  Allowance  for  Discount  Available.  Our 
accounts  payable  are  less  serious  by  the  amount  of  discount 
offered  us,  and  since  we  cannot  well  write  down  the  payables  now 
(else  they  will  not  tally  with  the  bills),  we  may  set  up  a  contra 


THE  CONTENT  OF  COMMON  ACCOUNTS  III 

account.  This  is  debited  for  the  discount  available  at  the  time  of 
adjusting  the  books.  The  complementary  credit  is  ultimately 
transferable  to  Converted  Assets  (or  other  similar  account),  and 
is  discussed  in  connection  with  nominal  accounts. 

Provision  for  Hazard.  Every  business  house  takes  certain 
risks  of  mischance,  and  yet  the  mischance  may  never  in  a  long 
career  occur.  A  good  illustration  of  this  is  fire  losses  —  for  mod- 
em fire  insurance  tends  to  force  the  insured  to  bear  a  part  of  the 
risk,  and  therefore  not  the  whole  of  the  burden  can  be  covered  by 
insurance  policies.  This  means  that  every  year  in  which  no  fire 
loss  occurs  a  business  house  should  accumulate  something  as  this 
year's  share  of  the  burden  of  loss  that  in  some  degree  of  probabil- 
ity will  happen  sometime.  To  leave  the  loss  to  be  suffered  wholly 
by  the  year  in  which  the  fire  chances  to  fall  would  be  unfair  to 
that  year  —  for  the  risk  of  loss  belongs  to  all  the  years.  Hence  at 
the  close  of  every  period  recognition  should  be  given  to  the  fact 
that  some  of  the  assets,  though  still  intact,  are  in  a  sense  doomed 
to  disappearance  by  mischance  and  that  a  portion  of  the  loss  in- 
volved belongs  to  the  past  period.  The  subsequent  periods,  more- 
over, though  they  inherit  the  assets  intact,  should  inherit  a  cer- 
tain margin  for  shrinkage  or  loss  which  will  not  be  held  chargeable 
to  them  if  the  loss  occurs  during  their  term.  Provision  for  Fire 
Hazard  is  an  illustration  of  this  sort  of  thing.  The  entry  would 
debit  Insurance  Charges  and  credit  Provision  for  Fire  Hazard. 
The  former,  as  we  have  already  seen,  is  transferred  to  Converted 
Assets,  or  Goods-in-Process  (or  a  substitute  for  one  of  them) ;  and 
the  latter  is  a  balance-sheet  item,  which  represents  neither  pro- 
prietorship nor  liability,  but  indicates  that  though  the  assets  are 
not  yet  impaired  by  fire  they  must  not  be  counted  on  for  the  fu- 
ture to  realize  the  book  value.  A  purchaser  would  give  less  for 
a  vessel  which  a  submarine  torpedo  was  known  to  be  approach- 
ing, even  though  the  excellence  of  the  aim  were  problematical, 
than  for  a  vessel  outside  the  danger  zone.  The  vessel  is  still  in- 
tact, but  the  approach  of  the  probable  moment  of  impact  affects 
its  value.  The  Provision  for  Fire  Hazard,  though  it  measures  a 
much  less  serious  probability  of  loss  than  the  torpedo,  represents 
nevertheless  the  supposed  degree  of  approach  of  the  final  mis- 
chance which  will  be  observed  only  as  a  single  and  momentary 


112  THE  FUNDAMENTALS  OF  ACCOUNTING 

event.  This  provision  for  fire  hazard  should  be  accumulated 
over  a  series  of  years  to  a  sum  sufficient  to  cover  the  chance  of  loss 
on  the  uninsurable  margin  of  value  of  all  property  subject  to  the 
risk.  Its  treatment  when  the  loss  precedes  the  accumulation  of 
the  provision  is  discussed  in  Chapter  XVII. 

OWNERSHIP-CLAIM  ACCOUNTS 

Proprietors*  Investment.  Usually  the  investment  of  propri- 
etors is  kept  in  a  separate  account  for  each  proprietor  by  name,  as 
*^John  Doe,  Investment,"  or  "John  Doe,  Capital."  The  part- 
nership agreement  will  of  course  show  what  investment  is  to  be 
maintained  by  each  partner  and  how  profit  and  loss  is  to  be 
shared  by  each;  and  this  account  is  to  show  how  closely  the  part- 
nership agreement  is  followed  in  respect  to  investment,  and  when 
the  division  of  profit  or  loss  is  to  be  affected  by  investment  this 
account  will  be  required  for  information  in  that  connection  also. 
In  case  of  dissolution,  the  investment  of  partners  is  important 
for  determining  the  division  of  net  assets  or  the  responsibility  for 
net  liabilities.  Though  the  investment  accounts  are  credited  for 
sums  intrusted  to  the  business  as  called  for  by  the  agreement,  they 
are  not  credited  for  loans  made  to  the  business  by  proprietors. 
They  are  debited  for  reduction  of  investment  by  withdrawal.  In 
the  case  of  single  proprietorship,  profits  and  withdrawal  of  profits 
often  are  carried  to  the  account  with  investment.  This  sacrifices 
some  statistical  information,  but  otherwise  does  no  harm.  In 
partnerships  this  should  not  be  done  unless  all  partners  always  at 
the  same  time  make  such  withdrawals  of  profits  as  may  be  mutu- 
ally agreed  upon  beforehand.  Usually  withdrawals  of  profits  are 
fixed  by  the  partnership  agreement,  and  separate  accounts  should 
be  kept  to  indicate  how  closely  the  agreement  is  followed. 

Proprietors*  Drawings.  In  order  to  distinguish  statistically 
between  capital  invested,  profits  earned,  capital  withdrawn,  prof- 
its withdrawn,  and  profits  accumulated  in  the  business,  an  ac- 
count is  usually  kept  for  each  proprietor  to  cover  items  not  in- 
vested. This  may  be  called,  for  example,  "John  Doe,  Drawings/' 
or  "John  Doe,  Personal."  To  it  are  credited  the  following,  pro- 
vided by  the  partnership  agreement:  salary,  interest  on  invest- 
ment, and  profits.    To  it  are  debited  drawings  for  personal  use, 


THE  CONTENT  OF  COMMON  ACCOUNTS  II3 

charges  for  personal  service  or  personal  purchases  provided  or 
paid  for  by  the  business,  like  goods  taken  from  the  store,  and 
losses.  This  account  may  have  a  debit  balance  during  an  earning 
period,  for  profits  may  be  drawn  (if  the  partnership  agreement 
provides  for  this)  in  advance  of  the  adjustment  of  the  books  for 
the  balance  sheet.  If  at  the  end  of  the  period,  after  the  books 
have  been  adjusted,  it  has  a  credit  balance,  this  balance  may  be 
transferred  to  the  investment  account  if  the  undrawn  profits  are 
meant  to  be  retained  as  investment,  or  it  may  remain  temporarily 
as  a  liability  of  the  business  to  the  partner  for  intended  later  with- 
drawal. 

Proprietors*  Loans.  As  already  indicated,  loans  made  by  a 
partner  are  not  credited  to  the  investment  account,  for  unless 
the  business  is  insolvent  they  are  not  subject  to  the  hazards  of 
the  business  except  as  loans  by  outsiders  are  so  subject,  and  a 
partner  is  entitled  to  withdraw  his  loan  in  accordance  with  the 
terms  of  the  loan  exactly  as  any  other  creditor  is  entitled  to  do. 
For  this  reason,  an  accoimt  should  be  kept  for  loans  by  partners. 
They  should  not  be  consolidated  with  other  loans,  however,  for  in 
case  of  insolvency  they  stand  in  a  peculiar  relation  (suggested  by 
Chapter  XX),  less  with  respect  to  the  other  partners  than  with 
respect  to  creditors. 

Capital  Stock.  In  corporations,  as  already  indicated,  propri- 
etorship is  evidenced  by  certificates  of  stock,  which  are  recorded 
in  a  special  account.  Since  the  peculiarities  of  this  account  are 
numerous  and  little  affect  other  accounts,  discussion  is  postponed 
to  a  chapter  devoted  to  the  peculiarities  of  corporation  accoimts, 
Chapter  XVI. 

Bonds  Issued.  In  an  incorporated  business  the  account  for 
ownership- claims  next  in  importance  to  proprietorship  is  Bonds 
Issued.  This  represents  the  amount  which  the  corporation  has 
pledged  itself  to  pay  in  a  term  of  years  in  return  for  loans  made  to 
it  in  large  amount.  The  account  is  credited  for  the  face  value  of 
the  bonds  issued,  and  is  debited  for  payments.  The  subject  of 
bonds  is  complicated,  and  will  be  discussed  in  a  rather  elementary 
way  in  Chapter  XXI. 

Notes  Payable.  Notes  payable  are  virtually  the  reverse  of 
notes  receivable.    Notes  Payable  represents  formal  negotiable 


114  THE  FUNDAMENTALS  OF  ACCOUNTING 

promises,  of  the  business  on  whose  books  the  account  stands,  to 
pay  cash;  and  this  apphes  to  acceptances  of  drafts  as  well  as  to 
promissory  notes;  ^  and  it  does  not  usually  include  interest  on 
such  notes,  even  when  the  notes  bear  interest,  for  notes  are  more 
easily  identified  on  the  books  when  entered  at  face  value,  and  the 
interest  is  more  conveniently  handled  in  a  separate  account. 
This  account  is  credited  when  notes  are  issued  or  given  and  when 
drafts  are  accepted,  and  it  is  debited  when  the  notes  or  drafts  are 
paid  either  in  full  or  in  part.  It  is  also  called  "Bills  Payable." 
Mortgage  Notes  Payable.  Just  as  one  reports  mortgage  notes 
held  as  Mortgage  Notes  Receivable,  one  should  report  such  notes 
issued  as  Mortgage  Notes  Payable.  Indeed,  it  is  more  important 
on  this  side  of  the  balance  sheet  than  on  the  other  that  these  notes 
be  separately  reported,  for  in  case  of  insolvency  they  would  con- 
stitute a  claim  to  specific  assets  and  probably  be  fully  paid,  thus 
reducing  the  share  of  assets  remaining  for  partial  payment  of  re- 
maining liabilities.  Sometimes  they  are  reported  on  the  balance 
sheet  by  deduction  from  the  asset  side  rather  than  as  liabilities,  to 
show  the  equity  in  the  mortgaged  property,  rather  than  its  gross 
value,  thus: 

Real  Estate  $200,000 

Less  Mortgage  Notes  Payable  75,000 

$125,000 

This  makes  clearer  the  situation  with  respect  to  solvency,  or  abil- 
ity to  pay  debts,  but  it  is  not  so  satisfactory  for  general  purposes; 
for  it  detracts  from  the  value  of  the  balance  sheet  as  a  clear  sum- 
mary statement  of  the  property  controlled  and  used  by  the  busi- 
ness in  earning  its  income. 

Accounts  Payable.  Liability  for  merchandise,  for  raw  mate- 
rial, and  for  manufacturing  supplies  (that  is,  for  principal  purchase 
of  tangible  things  to  be  quickly  converted  and  disposed  of)  is 
commonly  credited  to  Accounts  Payable,  This  account  is  debited 
for  payments  on  such  accounts  and  for  cash  discounts  which  re- 
duce the  amount  required  to  be  paid  when  payment  is  made 
early.  Its  balance  usually  shows  a  liability  greater  than  the 
actual,  for  discounts  offered  can  commonly  reduce  the  payments. 
In  such  cases,  a  contra  account.  Allowance  for  Discount  Available, 
I  A  discussion  of  drafts  will  be  foiind  in  Appendix  A. 


THE  CONTENT  OF  COMMON  ACCOUNTS     II5 

can  be  established,  as  discussed  earlier  in  this  chapter  on  page  no. 
Miscellaneous  Kabilities  not  for  principal  purchases  of  quickly 
convertible  assets  are  not  credited  to  Accounts  Payable  but  to  one 
of  the  accounts  discussed  in  the  next  paragraph. 

Other  Payables.  Liability  for  wages,  for  commissions,  for 
general  expenses  and  services  (like  lighting  and  telephone  connec- 
tions) ,  for  supplies,  for  equipment,  and  for  similar  items  not  enter- 
ing into  sales  except  remotely,  is  credited  commonly  to  Vouchers 
Payable,  by  a  bookkeeping  device  to  be  described  in  Chapter 
XIII,  or  to  special  accounts,  like  Wages  Liability,  Rent  Liability, 
etc.  The  complementary  debit  is  to  the  appropriate  nominal 
account,  like  Wages,  Commission  Charges,  Light,  Telephone  and 
Telegraph,  Rental,  Taxes,  and  General  Expenses,  or  to  the  appro- 
priate real  account,  like  Supplies,  and  Equipment.  When  pay- 
ment is  made,  the  Hability  account  is  debited. 

Accrued  Liabilities.  Just  as  assets  may  be  constantly  accruing 
with  mere  lapse  of  time,  like  claims  for  interest,  for  rental,  and  for 
royalties,  liabilities  of  the  same  sort  may  be  accruing  against  the 
business.  We  may  well  illustrate  this  with  a  case  involving  inter- 
est. If  we  borrow  $1,000  on  December  16  on  a  note,  bearing  in- 
terest at  6%,  and  payable  in  60  days,  day  by  day  this  interest  is 
accruing  against  us  and  on  December  31  our  balance  sheet  must 
show  Interest  Accrued  Liability  for  $2.50.  The  debit  which  will 
serve  as  a  complement  to  this  credit  is  Interest  Charges.  A  cor- 
responding method  is  used  for  Rental  Accrued  Liability,  Taxes 
Accrued  Liability,  etc. 

Liability  on  Prepajrments.  Just  as  assets  may  consist  of  items 
prepaid  but  immediately  thereafter  subject  to  exhaustion  by 
mere  lapse  of  time,  so  liability  may  consist  of  liabihty  on  accoimt 
of  prepayments  to  us  by  others.  This  liability  may  be  looked  at 
in  either  of  two  ways:  it  is  liability  to  perform  service,  as  to  allow 
the  use  of  money  for  which  interest  has  been  paid  in  advance  or 
the  use  of  a  building  for  which  rental  has  been  paid  in  advance;  or 
it  is  financial  responsibility  for  money  delivered  in  advance  of  the 
performance  of  the  service.  We  may  again  take  a  case  of  interest 
for  illustration.  If  we  len'd  money  on  a  $1,000  note,  not  bearing 
interest  and  due  in  two  months,  we  shall  lend,  if  we  discount  at 
6%,  $990.    We  shall  debit  Notes  Receivable  $1,000,  shall  credit 


Il6  THE  FUNDAMENTALS  OF  ACCOUNTING 

Cash  $990,  and  must  credit  Interest  Unearned  $10.^  This  last 
item  is  a  liability:  we  have  collected  the  interest  before  we  have 
rendered  the  service.  Day  by  day,  however,  the  service  is  ren- 
dered by  allowing  the  use  of  the  money,  and  the  HabiUty  is  re- 
duced. The  entry  for  adjusting  the  books  is  a  debit  to  Interest 
Unearned  and  a  credit  to  Interest  Earned.  A  corresponding 
method  is  used  for  Rentals  Unearned,  etc.  A  particularly  good 
illustration  of  a  Hability  on  prepayments  is  that  of  long-term  sub- 
scriptions to  magazines. 

Undivided  Profits  and  Surpluses.  In  corporations  more  than 
in  unincorporated  businesses  it  is  common  to  accumulate  some  of 
the  profits  rather  than  distribute  all  of  them  or  even  allocate 
them  to  the  accounts  of  proprietors.  In  an  unincorporated  busi- 
ness, a  surplus  would  be  simply  an  undivided  credit  to  partners, 
left  undivided  as  an  indication  that  a  part  of  the  assets  arising 
from  profits  were  not  intended  to  be  withdrawn  but  accumulated 
for  emergencies  or  for  a  special  purpose.  Because  Surplus  is  more 
common  in  connection  with  corporations,  it  is  discussed  more 
fully  in  Chapter  XVI.  What  is  said  there  applies,  mutatis  mu- 
tandis^ to  partnerships. 

Contingent  Liabilities.  It  is  not  imcommon  to  incur  a  liability 
contingent  on  the  failure  of  ourselves  or  of  others  to  comply  with 
conditions  agreed  upon.  Most  common  of  such  liabilities  are 
endorsements  of  notes  of  others,  as  we  saw  in  connection  with 
Notes  Receivable,  under  Notes  Receivable  Discounted,  Some- 
times, however,  notes  are  endorsed  for  mere  accommodation, 
without  immediate  financial  interest.  Such  are  endorsements  or 
guarantees  by  controlling  railroads  of  the  notes  and  bonds  of  con- 
trolled roads.  Many  businesses  act  as  bondsmen  for  employees 
who  get  into  the  police  courts  (for  the  value  of  a  trained  workman 
is  great),  giving  not  actual  property  as  a  bond,  but  a  promise  of 

*  Lest  the  reader  may  think  we  are  multiplying  interminably  the  accounts  for 
different  aspects  of  interest,  and  similar  business  forces,  it  may  be  well  to  note  that 
(i)  all  these  accounts  are  in  use,  (2)  the  novice  is  much  more  likely  to  grasp  the 
significance  of  the  various  aspects  of  interest  if  he  has  an  account  for  each  aspect, 
and  (3)  when  he  is  sufficiently  advanced  to  keep  his  head  easily  through  all  the  as- 
pects in  one  account,  he  will  be  shown  a  single  account  for  such  things  in  Chapter 
XrV.  Such  a  single  account  was  common  in  the  old  days  of  bookkeeping,  but  it 
is  more  complicated  in  theory  than  the  more  modem  accounting  device  of  separate 
accounts. 


THE  CONTENT  OF  COMMON  ACCOUNTS      II7 

payment  if  the  employee  breaks  the  conditions  of  his  bail.  Such 
a  promise  is  a  contingent  liability,  and  should  be  recorded.  It  is 
often  customary,  too,  for  contractors  to  guarantee  the  completion 
of  work  within  a  certain  time  limit,  and  to  agree  to  forfeit  a  speci- 
fied sum  for  each  day  or  week  (up  to  certain  limits)  in  which  the 
work  remains  uncompleted  after  the  expiration  of  the  time  agreed 
upon  for  completion.  Since  the  sacrifice  which  failure  of  com- 
pletion will  involve  may  be  appreciable  and  possibly  even  disas- 
trous, the  contingency  should  be  recorded.  There  is  no  exact 
title  which  should  be  used  for  a  contingency,  but  appropriate 
titles  usually  suggest  themselves.  Such  awkwardness  as  the 
record  may  make  usually  Ues  in  the  debit  complementary  to  the 
credit  for  the  liability.  That  debit  is  usually  a  contingent  asset, 
though  it  may  be  a  contingent  loss.  In  the  case  of  the  guarantee 
of  bonds  by  a  railroad,  an  intelligible  entry  is  a  debit  to  Contin- 
gent Lien  on  Property  of  Controlled  Roads  and  a  credit  to  Guar- 
antee of  Bonds  of  Controlled  Roads.  These  tell  the  whole  truth 
on  the  balance  sheet  —  an  asset  and  a  Uability.  Any  one  familiar 
with  accounts  can  see  that  both  are  contingent. 

NOMINAL  ACCOUNTS 

Nominal  Accounts  tied  to  Real  Accounts.  Almost  all  the  com- 
mon nominal  accounts  have  already  been  discussed  in  connection 
with  their  related  real  accounts,  for  since  all  nominal  accounts 
are  merely  real  accounts  either  behind  the  times  or  ahead  of  them, 
the  relation  is  close.  All  items  of  a  real  account  found,  at  the 
time  of  adjustment  for  the  balance  sheet,  to  be  converted  are 
transferred  from  that  account  and  carried  to  another  that  by  its 
title  suggests  to  any  one  familiar  with  accounts  not  only  that  the 
thing  has  been  converted  but  also  (for  statistical  purposes)  the 
nature  of  that  conversion.  We  have  already  seen  in  the  ear- 
lier parts  of  this  chapter  the  following  nominal  accounts  pro- 
vided: Supplies,  Depreciation,  Interest  Earned,  Interest  Charges, 
Rental  Earned,  Rental  Charges,  Insurance  Charges,  Commission 
Earned,  Commission  Charges,  Wages,  Light,  Telephone  and 
Telegraph,  Taxes,  General  Expenses. 

Nominal  Accounts  with  Double  Aspect.  Sometimes  what  is 
treated  above  in  two  accounts,  Interest  Earned,  and  Interest 


Il8  THE  FUNDAMENTALS  OF  ACCOUNTING 

Charges,^  is  treated  in  one  account,  Interest.  If  the  business  is 
almost  exclusively  a  borrower,  or  a  lender,  the  single  word  in  the 
title  is  adequate,  but  if  it  has  activity  in  both  directions  the  value 
of  statistical  figures  in  each  direction  is  likely  to  be  appreciable 
and  two  accounts  should  be  kept.  The  two  sides  of  the  same 
account,  debits  for  interest  charges  and  credits  for  interest 
earnings,  would  suffice  if  no  correction  entries  were  ever  made; 
but  so  often  are  changes  and  adjustments  made,  because  of  er- 
rors or  misunderstandings,  that  to  assume  that  all  debits  are  for 
charges  and  all  credits  are  for  earnings  would  impair  the  value  of 
statistics  drawn  from  the  ledger.  The  only  sure  way  is  to  have  an 
account  for  each,  and  carry  to  the  appropriate  account  all  correc- 
tions and  adjustments,  so  that  the  balance  and  the  total  of  that 
account  can  mean  only  one  kind  of  thing.  The  same  thing  is  true 
of  rental  and  of  commission  discussed  above,  of  discounts  to  be 
discussed  below,  and  of  any  other  type  of  service  which  we  both 
receive  and  render.  We  are  about  to  apply  it  also  to  merchandise. 
Sales.  For  the  same  reason  that  two  accounts  are  desirable 
for  interest  in  many  cases,  as  given  in  the  preceding  paragraph, 
several  accounts  are  desirable  for  merchandise.  We  need  to  know 
statistically  eight  leading  facts  about  merchandise:  inventory  at 
the  beginning,  purchases,  returned  purchases,  discount  taken, 
sales,  returned  sales,  discount  given,  inventory  at  the  end;  the  rea- 
son for  knowing  each  is  noted  in  connection  with  each.  We  also 
should  know  discount  available  and  discount  offered.  One  of  the 
most  important  facts  we  can  know  about  any  business  is  the  per- 
centage of  various  expenses  to  the  volume  of  business,  so  that  bad 
economy,  waste,  and  extravagance,  can  be  stopped.  We  cannot 
find  percentages  unless  we  know  sales.  Therefore  sales  must  be 
segregated  in  an  account,  Sales.  This  must  be  credited  for  sales 
made  and  debited  for  overcharges  by  error.  Returns  of  goods 
sold  but  found  unsatisfactory  must  not  go  to  this  account  and 
reduce  this  figure  of  sales,  for  expenses  of  selling  are  virtually  as 
great  for  goods  that  come  back  as  for  goods  that  stay  sold.  The 
final  credit  to  Sales  should  show  the  total  sales  made  —  the 
gross  return  from  the  conversion  of  other  assets  into  sold  goods. 
We  shall  bring  this  gross  return  into  connection  with  deductions 
*  The  term  "charges"  means  "burden,"  "cost,"  "expense." 


THE  CONTENT  OF  COMMON  ACCOUNTS  II9 

from  it  and  costs  of  getting  it,  as  shown  by  the  other  accounts, 
in  the  last  part  of  this  chapter,  under  a  clearing  account. 

Returned  Sales.  Though  the  expense  of  selling  goods  is  virtu- 
ally as  great  for  those  that  come  back  as  for  those  that  stay  sold, 
the  goods  themselves  have  not  been  converted,  and  we  must 
recognize  the  return  of  the  goods  in  finding  profit  or  loss.  We 
also  need  statistics  of  the  proportion  of  returned  goods.  If  this 
runs  unduly  or  increasingly  high,  our  sales  pohcy  may  need  revi- 
sion. Returned  Sales  is  debited  for  returned  sales.  We  shall 
bring  this  into  conjunction  with  the  other  merchandise  accounts 
in  the  clearing  account. 

Purchases.  The  reverse  of  Sales  is  Purchases.  It  is  used  not 
only  for  finding  the  original  cost  of  goods  going  into  sales,  but  also 
for  finding  the  percentage  of  buying  expense  to  purchases.  It  is  of 
course  debited  for  purchases  made,  and  credited  for  overcharges, 
but  not  for  returned  purchases.  It  is  finally  transferred  to  the 
clearing  account. 

Returned  Purchases.  When  goods  purchased  are  returned  by 
the  business,  Returned  Purchases  is  credited.  It  is  finally  trans- 
ferred to  the  clearing  account. 

Freight  and  Cartage  on  Sales.  If  the  business  sells  its  goods 
deHvered,  delivery  is  one  of  the  costs  of  converting  goods  into 
cash  and  accounts  receivable.  An  account  should  be  kept  for 
that  cost.  If  delivery  equipment  is  kept,  separate  accounts 
should  be  kept  for  the  equipment  itself  (a  balance-sheet  account) 
and  for  the  various  expenses  connected  with  running  it.  The 
costs  of  deUvery  should  be  distinguished  from  other  costs.  If 
service  of  local  deUvery  is  extensive,  whether  engaged  from  out- 
side or  not,  it  should  be  debited  directly  to  Delivery.  If  de- 
livery is  only  occasional  and  incidental,  it  may  be  combined  with 
freight,  in  Freight  and  Cartage  on  Sales,  or  Outward  Freight 
and  Cartage.  This  goes  ultimately  to  the  clearing  account  for 
merchandise. 

Freight  and  Cartage  on  Purchases.  This  has  a  purpose  for 
purchases  similar  to  that  of  the  account  above  for  sales,  and  should 
be  handled  in  a  similar  fashion  —  debited  for  all  costs,  and  trans- 
ferred ultimately  to  the  clearing  account. 

Discount  Given.     We  have  seen  that  some  account  must  be 


I20  THE  FUNDAMENTALS  OF  ACCOUNTING 

debited  for  the  difference  between  the  face  of  Accounts  Receiva- 
ble and  the  cash  payment  when  customers  are  given  a  discoimt 
on  paying  promptly.  The  natural  account  to  debit  is  Discount 
Given.  If  payments  on  which  discounts  are  allowed  were  always 
made  in  the  year  when  the  sales  were  made,  this  would  be  simple; 
but,  as  we  have  seen,  the  first  pa)nnents  in  any  period  are  on  ac- 
count of  sales  of  the  previous  period,  and  these  should  have  been 
taken  into  account  at  the  time  of  adjusting  the  books  at  the  end 
of  that  period.  The  discounts  to  be  actually  given,  however, 
could  not  be  known  at  that  time,  and  therefore  the  figure  used  in 
adjusting  the  books  will  hardly  ever  tally  with  the  actual  final 
figure  for  the  bills  concerned.  If  one  is  particular  about  statistics 
on  the  operating  statement,  the  debit  at  the  end  of  a  period,  for 
discounts  offered  and  accompanied  by  a  credit  for  the  allowance, 
may  well  be  carried  in  an  account  separate  from  that  for  discounts 
actually  given.  This  may  well  be  Unexpired  Discount  Offered, 
so  that  at  the  time  of  adjusting  the  books  for  the  balance  sheet  the 
entry  is  a  debit  to  Unexpired  Discount  Offered  and  a  credit  to  Al- 
lowance for  Discoimt  Offered.  The  former  is  a  nominal  account, 
and  the  latter  is  real.  In  the  subsequent  period,  discounts  actu- 
ally given  on  old  sales  may  be  debited  to  Allowance  for  Discount 
Offered  (for  the  discount  already  taken  into  consideration  in  the 
preceding  period,  but  to  be  given  in  this  period  if  at  all),  and  dis- 
counts on  new  business  should  be  debited  to  Discount  Given. 
Both  Discount  Given  (representing  discounts  given  during  the 
period  on  business  of  the  period)  and  Unexpired  Discoimt  Offered 
(representing  discounts  offered  at  the  end  of  the  period  on  busi- 
ness of  the  period)  should  be  debited  to  the  clearing  account  for 
merchandise.  The  treatment  of  these  accounts  may  be  tabulated 
as  follows: 

Entering  at  the  end  of  a  period  discounts  offered  on  sales  made 
during  the  period  but  not  yet  due: 
Unexpired  Discount  Offered,  Dr.  Allowance  for  Discount  Offered,  Cr. 
(This  is  a  charge  against  the  period  of  sale.) 

Actually  giving  discounts  on  sales  of  the  preceding  period: 
Allowance  for  Discount  Offered,  Dr.  Accounts  Receivable,  Cr. 

(This  merely  cancels  the  Allowance  already  made  and  is  not  now 
a  charge  against  any  period.) 


THE  CONTENT  OF  COMMON  ACCOUNTS  121 

Actually  giving  discounts  on  sales  of  the  current  period: 
Discount  Given,  Dr.  Accounts  Receivable,  Cr. 

(This  is  a  charge  against  the  period  when  given,  which  is  also  the 
period  of  sale.) 

As  we  shall  see  in  Chapter  XIV,  these  entries  may  be  short-cut 
somewhat.  If  one  does  not  care  to  distinguish  between  discounts 
actually  given  in  a  period  and  those  figured  in  advance  as  be- 
longing to  the  sales  of  that  period  even  though  actually  taken  in 
a  later  period,  the  single  account,  Discount  Given,  will  serve  for 
both.  In  that  case,  it  will  be  debited  when  either  Allowance  for 
Discount  Offered  is  credited  for  adjustment  at  the  end  of  a  period, 
or  Accounts  Receivable  is  credited  for  discounts  given  in  a  period 
on  sales  of  that  period;  but  of  course  the  title  of  the  account  is 
somewhat  misleading  for  the  former  purpose. 

Discount  Taken.  For  discount  taken  on  purchases  we  need 
an  account  the  converse  of  Discount  Given,  i.e.,  Discount  Taken. 
This  may  be  credited  when  either  Accounts  Payable  is  debited 
for  discounts  taken  in  the  period  on  purchases  of  the  period,  or 
Allowance  for  Discount  Available  is  debited  for  the  adjustment 
at  the  end  of  the  period.  If,  however,  we  are  to  distinguish  on 
our  operating  statement  between  discounts  actually  taken  in 
any  period  and  those  available  at  the  end  of  a  period  but  not 
taken  until  the  subsequent  period,  we  must  have  another  ac- 
count to  credit  when  we  debit  Allowance  for  Discount  Available 
at  the  end  of  a  period.  This  may  well  be  called  Unexpired  Dis- 
count Available.  It,  like  Discount  Taken,  will  be  transferred 
ultimately  to  the  clearing  account  for  merchandise.  In  any  pe- 
riod, discounts  taken  on  purchases  of  a  preceding  period  would 
be  credited  not  to  Discount  Taken,  but  to  Allowance  for  Discount 
Available;  for  the  discount  has  already  been  taken  into  the  ac- 
counts through  the  closing  entry  of  the  previous  period. 

Disposition  of  Balance  of  Allowance  for  Discounts.  If  the 
allowance  for  discounts  set  up  at  the  end  of  a  period  proves  to  be 
excessive,  i.e.,  if  it  is  in  excess  of  the  discounts  actually  taken  or 
given  on  old  business  in  the  subsequent  period,  the  excess  is  a  loss 
or  gain  of  the  new  period.  If  we  are  allowed  to  take  a  discount  in 
any  period  on  the  purchases  of  an  earlier  period  and  fail  to  do  so, 
the  forfeited  discount  is  a  loss  of  the  period  in  which  we  fail  to 


122  THE  FUNDAMENTALS  OF  ACCOUNTING 

take  that  advantage,  and  hence  any  debit  balance  on  Allowance 
for  Discount  Available  after  all  discount  dates  have  gone  by 
should  be  carried  to  Loss  and  Gain  as  an  expired  (wasted)  asset. 
The  account  cannot  have  a  credit  balance.  Any  credit  balance 
on  Allowance  for  Discount  Offered,  on  the  other  hand,  should  be 
carried  to  Loss  and  Gain  as  a  gain  arising  from  the  fact  that  cus- 
tomers have  paid  more  on  their  bills  than  the  minimum  required. 
This  is  further  discussed  in  the  next  paragraph. 

Cash  Discounts  Forfeited.  Curiously  many  business  men  have 
entirely  misunderstood  the  statistical  value  of  figures  for  cash 
discounts.  We  need  to  observe  not  only  how  much  less  valuable 
are  our  accounts  receivable  and  how  much  less  serious  are  our 
accounts  payable  because  of  these  discounts,  but  also  what  guid- 
ance the  figures  can  give  us  for  the  conduct  of  our  business.  If 
we  have  the  right  to  take  $5,000  in  discounts  by  paying  our  bills 
promptly,  it  is  the  height  of  foolishness  not  to  pay  promptly  — 
provided  we  can  raise  the  money,  and  we  have  already  seen  that 
the  rate  of  cash  discount  is  usually  much  higher  than  the  inter- 
est rate  for  borrowed  money,  and  so  it  pays  to  borrow.  What, 
then,  does  a  man  need  really  to  know  about  his  discounts?  Two 
things  —  the  discounts  that  he  might  take,  and  those  that  he  does 
take.  He  cannot  afford  to  set  off  discounts  given  against  dis- 
counts taken  and  say  that  he  is  losing  nothing  if  only  he  takes  as 
many  discounts  as  he  gives;  for  the  discounts  taken  by  his  cus- 
tomers have  nothing  to  do  with  the  discounts  which  he  takes.  If 
customers  pay  slowly,  they  may  force  him  to  borrow  in  order  to 
take  his  discounts,  to  be  sure,  but  such  customers  pay  him  an 
extra  price  for  delay  (i.e.,  the  full  billed  price  for  goods  when  they 
might  pay  a  smaller  price),  and  this  extra  price  is  much  more  than 
the  interest  which  he  will  have  to  pay  if  he  borrows  as  a  means  of 
meeting  his  own  bills  and  taking  the  discounts  offered  him.  So 
he  should  take  all  discounts  offered  him,  and  he  needs  to  be  warned 
at  once  when  any  discount  is  forfeited.  Indeed,  he  stands  more  in 
need  of  information  about  discounts  not  taken  by  himself  than 
about  those  actually  taken  by  either  himself  or  his  customers. 
Discounts  not  taken  by  him  are  a  loss  of  all  that  they  amount  to 
above  the  interest  on  the  money,  and  they  constitute  a  loss  with- 
out any  return  —  provided  he  has  or  can  borrow  the  means  of 


THE  CONTENT  OF  COMMON  ACCOUNTS  1 23 

payment.  Discounts  given  to  his  customers,  on  the  other  hand, 
are  not  losses  — •  they  are  mere  corrections  in  the  price  of  goods; 
for  prices  are  quoted  on  the  assumption  that  customers  will  pay 
late,  that  they  must  pay  more  for  delayed  payment  and  risk,  and 
hence  when  they  pay  early  they  are  entitled  to  an  allowance  for 
the  privilege  (charged  in  the  bill)  which  they  did  not  use.  What 
accounts  should  show  for  purchases,  therefore,  is  a  net  debit  to 
Merchandise  of  the  lowest  cash  price  offered,  whether  discounts 
are  actually  taken  or  not.  The  difference  between  the  dis- 
counts actually  taken  on  the  purchases  of  the  current  period  and 
those  available  on  the  purchases  of  that  period  should  be  charged 
to  Discount  Lost,  which  is  not  a  cost  of  merchandise  but  of  poor 
management  or  bad  credit.  Similarly  sales  should  have  a  net 
credit  of  the  lowest  cash  price  only,  whether  discounts  are  taken 
or  not.  The  difference  between  the  offered  and  the  given  should 
be  credited  to  Discount  Collected — an  earning  from  capital  risked 
in  slow  accounts  receivable.  Forfeited  discounts  on  old  business 
are  automatically  cared  for  by  the  allowance  account  already 
described.  The  ideal  handling  of  payment  by  the  firm  of  a  bill 
for  purchases  of  the  current  year  follows: 

Dr.  Accounts  Payable  for  the  face  of  the  bill 
Cr.  Cash  for  the  net  amount 
Cr.  Discount  Taken  for  the  discount  taken 
Cr.  Merchandise  for  the  discount  lost 
Dr.  Discount  Lost  for  the  discount  lost 

The  discount  taken  is  in  any  case  closed  to  the  summary  account 
for  merchandise  at  the  end  of  the  period,  and  thus,  along  with 
Discount  Lost,  makes  the  correction  in  the  billed  cost  of  the  goods; 
but  whereas  discount  taken  reduces  the  cost  of  the  goods  in  real- 
ity and  costs  nothing  except  a  loss  of  interest,  discount  lost  costs 
cash  and  brings  no  return.  It  is  feasible  to  provide  special  col- 
imans  in  a  cash  book  (one  extra  colimin  will  serve  if  the  totals  are 
properly  handled)  to  give  this  important  information.  In  the 
illustrations  following  it  is  not  done,  however,  for  a  well  conducted 
business  will  not  lose  discounts  and  hence  needs  no  such  provi- 
sion. It  is  not  so  important  to  distinguish  Discount  Collected; 
for  the  item  is  not  controllable,  and  the  profit  is  in  Merchandise. 
Rental  Charges  and  Rental  Earned.    If  a  building  occupied 


124  THE  FUNDAMENTALS  OF  ACCOUNTING 

is  not  owned,  and  a  building  owned  is  let,  the  distinction  between 
the  two  aspects  of  rent  should  be  maintained  throughout;  for  the 
rental  of  the  building  occupied  is  an  expense  of  doing  business  and 
therefore  a  desired  statistical  figure,  and  the  building  owned  is 
independent  of  the  business  conducted  in  the  hired  building  and 
hence  figures  for  it  should  not  be  consolidated  with  figures  of  the 
other  business  —  to  the  confusion  of  both  sets.  When  the  ten- 
ant pays  water  charges,  insurance,  taxes,  etc.,  he  should  charge 
such  items  to  Rental  Charges;  for  he  is  concerned  with  the  total 
cost  to  him  of  the  premises  hired  and  has  no  need  of  statistical 
information  that  might  be  of  help  to  the  owner.  The  owner,  on 
the  other  hand,  if  he  has  many  properties,  will  need  information 
for  guidance,  and  should  not  directly  cancel  expenses  of  prop- 
erty against  income,  but  should  enter  to  Rental  Earned  only 
income  (and  correction  entries)  and  carry  expenses  to  separate 
accounts  for  them ;  but  the  owner  of  a  single  property,  like  the  ten- 
ant, could  carry  both  income  and  expenses  to  Rental  Earned, 
crediting  it  for  the  former  and  debiting  it  for  the  latter,  for  with 
few  entries  the  desired  items  of  information  can  be  more  easily 
picked  out  of  a  single  account  than  handled  in  various  accounts. 

Loss  from  Bad  Debts.  The  nature  of  losses  from  bad  debts 
and  the  method  of  indicating  probable  uncollectibility  have  al- 
ready been  discussed  in  this  chapter  in  connection  with  Allowance 
for  Bad  Debts.  The  common  account  to  represent  the  operat- 
ing debit  for  the  period  because  of  bad  debts  is  Loss  from  Bad 
Debts.  All  debts  written  off  as  bad  during  the  period  in  which 
they  were  incurred  are  debited  to  Loss  from  Bad  Debts  and  cred- 
ited to  Accounts  Receivable.  Then  Loss  from  Bad  Debts  is  an 
offset  to  Sales,  showing  the  reduction  in  actual  as  compared  with 
supposed  receipts  from  sales,  but  kept  in  a  special  account  for 
statistical  purposes.  These  are  not  all  the  losses,  however,  for 
sales  made  late  in  a  period  cannot  be  due  until  the  next  period  and 
hence  the  uncollectible  items  cannot  be  known  to  be  bad  until 
later;  so  in  order  to  find  our  profit  for  the  period  we  estimate  the 
uncollectible  accounts  receivable  at  the  end  of  the  period  and  add 
the  figure  to  the  losses  already  written  off.  A  simple  entry  is  to 
debit  Loss  from  Bad  Debts  and  credit  Allowance  for  Bad  Debts. 
This  is  satisfactory  except  to  those  who  say  that  an  estimated  loss 


THE  CONTENT  OF  COMMON  ACCOUNTS  125 

is  not  necessarily  an  actual  loss,  and  hence  Loss  from  Bad  Debts 
should  not  be  debited,  but  some  other  account  suggesting  that 
this  is  only  an  estimate  of  future  happenings  that  are  retroactive 
on  the  business  of  this  period.  This  distinguishes  between  two 
ways  of  judging  the  amount  of  loss.  As  a  matter  of  fact,  an  ac- 
count is  virtually  never  actually  known  to  be  bad :  even  a  discharge 
in  bankruptcy  is  sometimes  followed  by  a  paying  of  old  debts  out 
of  earnings  subsequent  to  bankruptcy,  and  death  in  insolvency  is 
sometimes  followed  by  an  honorable  paying  of  debts  by  heirs  who 
inherit  nothing  else.  So  virtually  all  losses  from  bad  debts  are 
estimated:  but  so  far  as  judgment  based  upon  knowledge  of  the 
particular  circumstances  of  a  specific  account  is  different  from 
judgment  based  upon  generalized  knowledge  of  the  collectibility 
of  accounts  as  a  whole,  two  accounts  for  such  judgment  of 
losses  may  be  worth  while.  If  the  second  account  is  adopted,  it 
may  well  be  called  Debt  Loss  Estimated.  This  will  be  debited 
instead  of  Loss  from  Bad  Debts  when  the  allowance  is  credited. 
Then  at  the  end  of  the  period  both  Loss  from  Bad  Debts  and  Debt 
Loss  Estimated  will  be  transferred  to  Converted  Assets  or  what- 
ever summary  account  is  used  to  bring  together  the  nominal  ac- 
counts and  find  profit  or  loss.  The  result  in  the  end  will  be  the 
same  as  if  only  one  such  account  had  been  kept,  but  the  statistics 
will  have  been  a  bit  more  accurate.  This  method  is  illustrated 
in  the  following  paragraph. 

Allowance  for  Bad  Debts  Illustrated.  Suppose  at  the  end  of 
the  first  year  of  business  the  accounts  receivable  were  $75,000  and 
no  notes  receivable  were  held.  Suppose  2%  was  estimated  as  the 
proper  allowance  for  bad  debts.  The  entry  for  adjustment  is  a 
debit  to  Debt  Loss  Estimated  and  a  credit  to  Allowance  for  Bad 
Debts  of  $1,500.  Suppose  during  the  following  year  $1,300  of 
old  debts  and  $3,700  of  new  are  written  off  as  bad,  and  at  the  end  of 
the  year  the  accounts  receivable  amount  to  $125,000  and  2%  is 
still  deemed  adequate  allowance.  During  the  year  Loss  from  Bad 
Debts  will  be  debited  $3,700  and  Allowance  for  Bad  Debts  will  be 
debited  $1,300,  and  Accounts  Receivable  will  be  credited  $5,000. 
At  the  end  of  the  year,  before  the  new  allowance  is  made,  the 
allowance  account  has  a  credit  balance  of  $200  and  it  now  needs 
$2,500  credit  balance  for  the  new  year.    So  it  must  have  a  new 


126  THE  FUNDAMENTALS  OF  ACCOUNTING 

credit  of  $2,300  to  set  it  right;  an  entry  debiting  Debt  Loss 
Estimated  and  crediting  Allowance  for  Bad  Debts  will  accom- 
plish this  result.  Both  Loss  from  Bad  Debts  and  Debt  Loss  Es- 
timated are  carried  to  the  proper  summary  account  (perhaps  Loss 
and  Gain) :  for  the  first  year  (supposing  no  accounts  were  written 
off  during  the  year)  the  amount  transferred  to  that  account  was 
$1,500  (Debt  Loss  Estimated  only); but  for  the  second  year  it  is 
$6,000  ($3,700  of  Loss  from  Bad  Debts  written  off  during  the  year, 
and  $2,300  of  Debt  Loss  Estimated  on  unpaid  bills  at  the  end  of 
the  year).  This  is  on  the  assumption  that  a  part  of  the  debts 
incurred  the  first  year  are  still  outstanding  and  not  written  off  at 
the  end  of  the  second,  and  that  $200  is  still  deemed  necessary  for 
them :  if  all  the  old  debts  are  cleaned  up,  or  cleaned  off,  however, 
the  balance  of  $200  on  the  old  allowance  is  unnecessary,  the 
charge  the  first  year  was  excessive,  and  the  $200  may  be  trans- 
ferred, from  the  Allowance  for  Bad  Debts,  to  Proprietorship  (to 
correct  an  original  excessive  charge  for  estimated  shrinkage  of 
assets) ;  and  in  that  case  the  new  Debt  Loss  Estimated  must  be 
debited  the  whole  $2,500  now  necessary  to  cover  estimated  bad 
debts  of  the  business  of  the  second  year,  and  the  Allowance  for 
Bad  Debts  will  be  credited  the  same  amount.  The  reverse  would 
be  the  case  if  the  allowance  had  been  deficient. 

Depreciation  and  Maintenance.  The  general  subject  of  de- 
preciation is  so  important  and  so  many  kinds  of  treatment  are 
possible  for  it  that  it  requires  discussion  in  a  chapter  by  itself. 
For  our  immediate  purpose  in  this  chapter  we  need  to  note  only 
a  few  facts.  The  first  is  that  so  closely  allied  to  depreciation  is 
maintenance  that  the  two  subjects  can  hardly  be  separately  dis- 
cussed. Depreciation  in  the  accounting  point  of  view  is  shrink- 
age in  the  value  of  property  with  respect  to  the  purpose  to  which 
it  is  appUed.  If  the  property  is  applied  to  manufacturing  pur- 
poses, a  loss  in  its  value  for  that  purpose,  due  to  shrinkage  in  pro- 
ductivity, to  deterioration  so  that  the  cost  of  running  is  increased, 
or  to  gradual  approach  of  the  end  of  its  usefulness,  is  deprecia- 
tion; allied  to  this,  and  usually  included  in  the  same  accoimt,  is 
obsolescence,  the  shrinkage  in  value  of  property  not  because  of 
any  changes  in  it  but  because  of  changes  outside  of  it  which  ren- 
der it  less  valuable  for  its  own  purposes — like  changes  in  fashion  or 


THE  CONTENT  OF  COMMON  ACCOUNTS  1 27 

custom  which  destroy  demand  for  its  product,  and  new  inventions 
and  new  demands  which  relegate  the  property  to  a  discarded  or 
semi-discarded  class.  Loss  of  value  in  other  respects  than  that 
to  which  the  property  is  applied  does  not  constitute  depreciation: 
a  fall  of  market  price  for  a  machine  that  is  to  be  used  and  not  sold, 
when  that  fall  in  price  is  due  not  to  changes  in  the  intrinsic  de- 
sirability of  the  machine  itself  (like  obsolescence  of  it)  but  applies 
to  similar  new  machines,  has  nothing  to  do  with  its  value  in  use 
for  the  owner  who  bought  under  the  old  price,  and  hence  does 
not  constitute  depreciation.  Property  held  for  sale,  however,  is 
properly  said  to  be  depreciated  when  the  market  value  falls,  for 
the  usefulness  of  such  property  is  market  usefulness  only.  Main- 
tenance, on  the  other  hand,  is  the  cost  of  overcoming  or  forestall- 
ing depreciation,  through  repairs  and  replacements.  In  the  cases 
in  which  maintenance  during  a  period  wholly  offsets  depreciation 
during  that  period,  for  the  period  as  a  whole  there  has  been  no 
depreciation,  but  only  maintenance;  in  the  cases  in  which  no  re- 
pairs or  replacements  have  been  made,  there  has  been  no  main- 
tenance, but  only  depreciation.  Commonly  repairs  and  replace- 
ments cannot  altogether  offset  depreciation,  and  hence  both  are 
suffered  as  costs.  They  should  be  distinguished  for  statistical 
purposes,  though  as  costs  there  is  no  difference  between  them:  for 
depreciation  consists  in  a  shrinkage  of  property,  and  maintenance 
consists  in  a  reduction  of  cash  to  avoid  shrinkage  of  other  prop- 
erty; but  both  are  costs  of  product.  They  are  discussed  more 
fuUy  in  Chapter  XVIII. 

Other  Nominal  Accounts.  Of  the  other  nominal  accounts  the 
titles  are  usually  sufficiently  suggestive.  A  few  comments  only 
are  necessary  here.  The  classification  of  expense  items  into 
groups  should  always  consider  the  statistical  information  desired, 
for  the  sole  purpose  of  maintaining  separate  accounts  for  different 
sorts  of  expenses  is  to  get  statistical  information.  A  business  ad- 
vertising widely,  for  example,  may  need  to  know  the  compara- 
tive value  of  advertising  by  newspapers,  by  magazines,  by  cir- 
culars; and  hence  it  may  need  three  accoimts  for  advertising,  one 
for  each  sort,  in  order  that  for  each  it  may  compare  the  return  with 
the  cost.  Most  business  houses,  on  the  other  hand,  need  only  one 
advertising  account.    This  matter  of  classification  of  expenses  is 


128  THE  FUNDAMENTALS  OF  ACCOUNTING 

discussed  more  fully  in  Chapter  XXII.  The  only  cautions  par- 
ticularly necessary  here  are  the  following:  ^'cash  discount"  for 
early  payment  of  bills  must  not  be  confused  with  discount  which 
is  prepayment  of  interest,  for  the  former  should  go  to  one  of  the 
accounts  discussed  on  pages  1 19-12 2,  and  the  latter  to  Interest 
Charges  or  to  Interest  Earned;  supplies  should  be  usually  sub- 
divided not  only  as  indicated  above,  but  office  supplies  should 
be  further  subdivided  as  Stationery  and  Printing,  Postage,  etc.; 
General  Expenses  must  not  be  a  cover  for  all  sorts  of  expenses  that 
ought  to  be  watched  individually,  like  traveling  expense,  heat, 
light,  and  insurance,  but  should  take  items  of  infrequent  occur- 
rence not  a  part  of  routine  operation,  like  auditor's  fees  and  oc- 
casional legal  fees  not  connected  directly  with  any  particular 
department  activity;  when  departments  are  maintained,  most  ex- 
penses either  should  be  kept  separate  from  the  start,  like  wages, 
light,  heat,  stationery,  etc.,  for  each  department,  or  should  be  dis- 
tributed among  departments  on  an  equitable  basis  when  the  books 
are  adjusted;  all  shrinkage  in  assets  and  increase  in  ownership- 
claims  when  not  the  result  of  a  direct  exchange  (of  an  item 
recognizable  on  the  books  under  its  own  name  for  another  so 
recognizable)  involves  a  conversion  or  indirect  exchange,  and 
some  nominal  account  is  intended  to  report  just  that  sort  of  con- 
version, and  hence  some  nominal  account  must  be  debited,  as  In- 
surance Charges  for  expirations  of  Insurance  Prepaid,  and  Rent 
for  Rent  Liability;  and  all  increase  in  assets  and  decrease  in 
ownership-claims  when  not  the  result  of  a  direct  exchange  in- 
volves a  conversion,  and  some  nominal  account,  intended  to 
report  just  that  sort  of  conversion,  must  be  credited,  as  Commis- 
sion Earned  for  an  increase  in  Commission  Accrued,  and  Interest 
Earned  for  a  decrease  in  Interest  Unearned.  These  last  two  points 
are  so  important  that  they  may  well  be  illustrated  anew  in  sum- 
mary form,  as  in  the  following  paragraph. 
I  Interest  Accounts  as  T3rpicaL  The  best  way  to  summarize  the 
relation  between  real  and  nominal  accounts  is  to  take  a  series  of 
transactions  related  to  a  single  business  force  and  see  the  record 
of  the  various  aspects  of  that  force.  For  this,  interest  is  the  most 
serviceable,  and  as  we  have  nowhere  had  the  interest  accounts 
treated  comprehensively  in  their  relation  to  one  another,  it  is 


THE  CONTENT  OF  COMMON  ACCOUNTS 


129 


well  to  examine  them  now  in  summary.  What  is  said  of  the  ac- 
counts for  interest,  moreover,  applies  to  those  for  any  other  force 
with  similar  aspects,  like  rent,  commission,  wages.  We  have  had 
six  interest  accounts  discussed  —  Interest  Accrued,  Interest  Pre- 
paid, Interest  Earned,  Interest  Accrued  Liability,  Interest  Un- 
earned, and  Interest  Charges.  We  will  suppose  four  transactions 
to  occur  in  the  last  month  of  the  year,  each  incomplete  in  its  effect 
xmtil  the  next  year,  each  t)^ical  of  a  kind  of  interest  transaction, 
and  the  four  together  covering  all  types  of  interest  transactions. 
The  four  are  as  follows,  arranged  in  tabular  form: 


Date  of 
transaction 

Kind  of 
transaction 

What  given 

Amount 

given 

What  got 

Amount  got 

Note 
hearing 
interest 

Dec.  I 
II 
16 
19 

borrowing 
lending 
lending 
borrowing 

Note  Payable 

Cash 

Cash 

Note  Payable 

$1000 

597 
1200 
2000 

00 
SO 
00 
00 

Cash 

Note  Rec. 
Note  Rec. 
Cash 

%  975 

600 

1200 

2000 

00 
00 
00 
00 

No 
No 
Yes 

Yes 

The  debits  and  credits  in  order,  in  accordance  with  the  content  of 
accoxmts  discussed  in  this  chapter,  are  as  follows: 


DeUts 

Credits 

Dec. 

I  Cash 
Interest  Prepaid 

975.00 
25.00 

Notes  Payable 

1000.00 

Dec. 

11  Notes  Receivable 

600.00 

Cash 

Interest  Unearned 

597-50 
2.50 

Dec. 

16  Notes  Receivable 

1200.00 

Cash 

1200.00 

Dec. 

19  Cash 

2000.00 

Notes  Payable 

2000.00 

On  Dec.  31,  at  adjusting  the  books,  we  should  have  to  note  all 
decreases  in  prepayments  and  increases  in  accrued  items  as  fol- 
lows (following  the  same  order  of  notes  as  before,  and  indicating 
the  number  of  days  used  for  each  entry) : 

Debits  Credits 

Interest  Charges  5 .  00        Interest  Prepaid  5 .  00 

(30  ds.  expiration  of  prepayment  on  note  of  Dec.  i) 
Interest  Unearned  2 .  00        Interest  Earned  2 .  00 

(20  ds.  earned  on  prepayment  on  note  of  Dec.  11) 
Interest  Accrued  3.00        Interest  Earned  3.00 

(15  ds.  earned  on  accrual  on  note  of  Dec.  16) 
Interest  Charges  4.00        Interest  Accrued  Liability        4.00 

(12  ds.  accrual  of  liability  on  note  of  Dec.  19) 


IjO 


THE  FUNDAMENTALS  OF  ACCOUNTING 


Dr. 

Cr. 

3 

00 

20 

00 

9 

00 

4 

00 

50 

5 

00 

When  these  items  are  posted  our  six  interest  accounts  will  give 
us  the  following  balances: 


Interest  Accrued 
Interest  Prepaid 
Interest  Charges 
Interest  Accrued  Liability 
Interest  Unearned 
Interest  Earned 


Our  assets  of  interest  are  $23.00  (accrued,  and  prepaid),  our 
charges  are  $9.00,  our  liabilities  (accrued  against  us,  and  prepaid 
to  us)  are  $4.50,  and  our  earnings  are  $5.00.  This  means  net  as- 
sets (assets  less  liabilities)  of  $18.50,  and  net  charges  (charges  less 
earnings)  of  $4.00.  Observation  of  the  note  accounts  and  Cash 
will  prove  the  correctness  of  these  figures:  we  have  received 
$1,177.50  more  cash  than  we  have  given  up,  and  we  have  given  up 
$1,200  more  notes  than  we  have  received,  or  a  shrinkage  of  assets 
in  these  respects  of  $22.50;  but  our  net  assets  of  interest  are  $18.50, 
so  that  our  final  shrinkage  of  assets  is  only  $4.00.  Why  have 
we  lost  $4.00  of  assets  in  real  accounts?  Because  our  net  interest 
charges,  as  we  have  just  seen,  are  $4.00,  and  these  have  gone  into 
conversions:  Interest  Charges  and  Interest  Earned  are  the  nom- 
inal accoimts,  and  the  other  interest  accounts  are  real.  Interest 
Charges  and  Interest  Earned  go  upon  the  operating  statement  as 
conversions  and  yield  from  conversions  respectively,  the  final  re- 
sult of  all  conversions  showing  as  profit  or  loss;  and  the  other,  or 
real,  interest  accounts  go  on  the  balance  sheet  to  represent  the 
assets  or  liabilities  which  have  resulted  from  the  operations. 

CLEARING  ACCOUNTS 
The  Nature  of  Clearing  Accounts.  Often  we  desire  information 
not  only  regarding  the  details  of  operation  and  the  final  net  result 
of  all  operations  as  a  single  group,  but  regarding  certain  sub- 
divisional  groups  of  detail  —  that  is,  we  wish  to  see  not  only  in- 
dividual trees  and  the  forest  as  a  whole,  but  certain  sections  of  the 
forest  as  entities.  Clearing  accounts  perform  this  function,  bring- 
ing together  individual  accounts  to  form  a  group,  and  carrying  on 
the  net  figure  of  the  group  to  a  still  larger  group  or  to  the  final  ac- 


THE  CONTENT  OF  COMMON  ACCOUNTS     I3I 

count  for  Converted  Assets,  or  Loss  and  Gain,  or  what  not.  When 
they  do  this  they  may  be  called  "sununary  clearing  accounts." 
Often,  too,  in  order  to  make  administrative  decisions,  we  must 
gather  certain  group  information  for  inspection  in  one  aspect,  as 
total  cost  of  power,  and  then  observe  it  from  a  new  angle  in  its 
effect  on  department  costs,  as  distributed  to  departments  on  an 
equitable  basis.  Clearing  accounts  perform  this  function,  and 
when  they  do  this  may  be  called  *' distributive  clearing  accounts." 
One  account,  for  example.  Power,  gathers  all  the  elements  of 
power  cost,  like  fuel,  oil,  water,  depreciation,  and  power  wages, 
and  distributes  the  total  to  department  accounts,  so  that  we 
may  form  conclusions  regarding  not  only  fuel,  etc.,  individually, 
and  power  as  a  whole,  but  also  operations  of  individual  depart- 
ments. 

Clearing  Account  for  Merchandise.  It  is  common  to  bring  to- 
gether all  items  connected  with  direct  sales  and  direct  cost  of 
sales,  so  as  to  show  the  gross  profit  on  merchandise,  in  Trading, 
or  Merchandise.  This  is  done  by  transferring  to  this  accoimt  the 
balances  of  the  accounts  concerned.  This  clearing  accoimt  will  be 
debited  for  the  opening  inventory,  for  purchases,  for  freight  and 
cartage  inward,  for  freight  and  cartage  outward,  for  returned 
sales,  for  discount  given  on  sales,  and  for  unexpired  discount 
offered.  It  will  be  credited  for  sales,  for  returned  purchases,  for 
discoimt  taken  on  purchases,  for  available  discount,  and  for  the 
closing  inventory.  Loss  from  bad  debts  is  not  usually  carried 
to  this  account,  for  such  loss  is  a  matter  not  so  much  of  sales  as  of 
collections  (though  of  course  the  two  things  are  closely  connected, 
for  any  one  can  sell  goods  to  people  who  won't  pay),  and  we  wish 
to  compare  gross  profits  with  selling  costs.  The  final  balance  of 
the  clearing  account  is  carried  to  the  account  which  takes  the  ex- 
penses of  trading.  This  may  be  Loss  and  Gain,  if  there  are  no 
other  sources  of  income,  where  it  is  compared  \nth  the  expenses 
of  selling  goods:  or  it  may  be  a  special  or  new  clearing  account  for 
gathering  all  expenses  for  selling  into  one  place  with  gross  profit 
but  apart  from  profits  from  other  sources.  In  the  illustration 
following  it  is  assumed  that  the  gross  profit  is  carried  to  a  second 
clearing  account.  Trading. 


132  THE  FUNDAMENTALS  OF  ACCOUNTING 

Merchandise 


Inventory,  1/1/21 

128,000 

Purchases 

336,000 

Frt.  and  Cart.  Inward 

4,000 

Returned  Sales 

18,000 

Frt.  and  Cart.  Outward 

1,000 

Discount  Given 

6,500 

Unexpired  Discount  Offered 

3,000 

Trading  [balance] 

130,500 

627,000 

Sales 

486,000 

Returned  Purchases 

3,000 

Discount  Taken 

6.000 

Unexpired  Discount  Available 
Inventory,  1/1/22 

1,000 

131,000 

627,000 


The  opening  inventory  is  brought  from  the  account  which  was 
used  for  the  balance  sheet  at  the  beginning  of  the  period,  by  what- 
ever name  called.  The  closing  inventory  will  not  have  been 
previously  on  the  books,  but  will  be  put  on  the  books  by  the  proc- 
ess of  setting  up  this  clearing  account.  The  clearing  account 
will  be  credited  as  shown,  and  the  new  account  for  the  balance 
sheet  (which  may  be  used  directly  as  the  opening  item  for  next 
year's  clearing  account)  will  be  debited. 

Cash  Discounts  as  Profit  or  Loss.  Difference  of  practice  is 
found  in  the  treatment  of  cash  discounts.  Before  people  began 
to  analyze  business  transactions,  when  they  were  satisfied  with 
mere  bookkeeping  records  of  obvious  fact,  the  common  practice 
was  to  treat  discounts  given  to  customers  as  costs  of  business, 
just  like  wages,  and  to  treat  discounts  taken  on  purchases  as  earn- 
ings. This  practice  has  continued  in  many  businesses,  and  even 
is  recognized  as  satisfactory  by  some  government  bureaus  on 
reports  made  to  them.  It  neglects  the  fact  that  though  it  is  cus- 
tomary to  allow  a  liberal  margin  of  time  for  the  payment  of  bills, 
the  price  fixed  on  goods  always  takes  this  into  accoimt:  the  quoted 
price  always  includes  (usually  consciously  on  the  part  of  the  seller) 
two  elements  —  the  natural  (cash)  price  of  the  goods,  and  an  ad- 
ditional sum  as  compensation  for  waiting  for  payment  (involving 
interest  and  risk).  When,  then,  payment  is  made  early,  so  that 
interest  and  risk  are  saved,  the  discount  given  the  customer  is  not  a 
cost:  it  is  merely  the  reduction  in  charge  to  him  for  a  service  which 
he  did  not  get.  He  was  originally  charged  for  delay  in  payment: 
he  is  now  credited  to  cancel  the  charge  for  what  he  did  not  use. 
The  debit  for  discounts  given  is  then  really  a  correction  of  the 
excessive  price  at  which  the  goods  were  billed,  and  is  therefore 


THE  CONTENT  OF  COMMON  ACCOUNTS  I33 

absolutely  nothing  but  a  deduction  from  sales,  kept  in  a  separate 
account  for  statistical  purposes;  and  a  credit  for  discounts  taken 
is  similarly  not  a  gain,  but  a  correction  of  the  excessive  charge  to 
purchases,  kept  separately  for  statistical  use.  They  are  therefore 
carried  to  the  clearing  account  above,  and  are  treated  accordingly 
on  an  operating  statement,  as  shown  on  page  351.  It  is  also  true, 
as  pointed  out  on  page  122,  that  discounts  offered  by  us  and  to  ug 
are  reductions  in  the  price  of  the  merchandise  as  such,  whether 
they  are  utilized  or  not,  and  hence  should  be  carried  to  the  clear- 
ing account.  If  any  discounts  are  recorded  as  forfeited  on  sales 
or  on  purchases  of  the  period,  they  will  already  have  been  brought 
here,  to  correct  the  overcharges  or  the  overcredits,  as  we  have 
seen. 

Clearing  Account  for  Trading.  If  a  business  has  other  sources 
of  income,  as  interest  on  loans,  commissions  earned,  rentals  earned, 
it  should  not  combine  sources  of  income  in  such  fashion  as  to 
destroy  the  significant  facts  about  any  source.  The  expenses  of 
the  trading  end  of  the  business  should  be  compared  with  the  gross 
profits  and  with  those  alone,  and  hence  gross  profits  should  not  be 
consolidated  with  profits  from  other  sources  until  after  the  ex- 
penses have  been  shown  with  the  gross  profits  in  the  same  accovmt 
to  give  a  final  trading  profit  or  loss.  This  purpose  is  served  by 
Trading,  a  clearing  account,  as  illustrated  below.  It  will  be  ob- 
served that  the  balance  of  Trading  is  carried  to  Income,  which  we 
are  here  assuming  to  be  the  final  loss  and  gain  account. 


130,500 


Trading 

Wages 

68,000 

Merchandise 

Rent 

S,ooo 

Light 

400 

Heat 

800 

Loss  from  Bad  Debts 

3,000 

[Etc.] 

5,300 

Income 

[balance] 

48,000 

130,500  130,500 


Often  the  title  "  Trading  "  is  used  for  the  account  shown  above 
under  the  title  of  "  Merchandise,"  and  what  we  have  here  carried 
to  Trading  may  then  be  carried  to  Loss  and  Gain;  but  as  some  ac- 
count should  show  the  net  effect  of  all  mercantile  business,  as  in 


134  THE  FUNDAMENTALS  OF  ACCOUNTING 

Trading  above,  and  as  no  other  titit  is  so  expressive  of  this,  that 
fact  is  sufl&cient  reason  for  this  use  of  it.  This  illustrates  the  flexi- 
bility of  terms;  but  in  interpreting  the  accounts  of  others  we  should 
not  assume  without  further  information  that  Trading  has  one  or 
the  other  content. 

Goods-in-Process,  Converted  Assets,  Manufacturing.  We  have 
already  seen  in  Chapter  VI  that  we  can  carry  our  various  ex- 
penses of  manufacturing  to  Goods-in-Process,  and  then  carry 
them  out  to  Finished  Goods  as  the  manufacture  is  completed. 
This  makes  Goods-in-Process  a  clearing  account.  We  saw  in 
Chapter  VII  that  to  Converted  Assets  were  carried  all  costs  of 
conversion  at  the  end  of  the  period,  and  that  these  costs  were  then 
transferred  to  the  appropriate  accounts  to  show  their  yield.  This 
makes  Converted  Assets  (though  the  title  used  here  was  designed 
for  the  purpose  of  illustration  and  is  not  often  found  in  business) 
a  clearing  account.  Sometimes  instead  of  Goods-in-Process  and 
Converted  Assets  we  find  Manufacturing,  but  serving  the  same 
purpose  and  handled  in  the  same  way  as  one  or  the  other  of 
them. 

Income,  Loss  and  Gain,  Undivided  Profits.  The  final  figure  of 
profit  for  any  period  is  usually  found  in  a  clearing  account  that 
groups  the  various  kinds  of  profit  and  kinds  of  loss  belonging  to 
the  period  in  question,  such  as  profit  from  trading,  earnings  from 
commission,  loss  on  real  estate  operations,  etc.  Income,  or  Loss 
and  Gain,  or  Undivided  Profits  (in  the  case  of  corporations), 
serves  this  purpose.  One  may  even  desire  to  accomplish  this  end 
by  installments,  and  have  several  such  clearing  accounts.  Some- 
times we  have  Operating  Expenses,  to  gather  all  expenses  of  prin- 
cipal business  into  one  account,  and  Operating  Earnings  to  gather 
all  kinds  of  principal  income,  and  Net  Earnings  to  combine  these 
as  a  final  figure  for  principal  business,  and  finally  Net  Income  as  a 
final  figure  for  all  kinds  of  income  ready  for  disposition.  Whethei 
one  shall  maintain  all  these  accounts  or  not  is  determined  by  one's 
interest  in  showing  on  the  ledger  in  permanent  form  various 
business  relations  that  should  be  shown  on  statements  in  any 
case. 

Distributive  Clearing  Accounts.  In  factories  and  in  depart- 
ment stores  a  matter  of  much  importance  is  the  distribution  of 


THE  CONTENT  OF  COMMON  ACCOUNTS  135 

space  costs  among  departments,  so  that  each  shall  bear  its  fair 
share.  The  bookkeeping  record  of  distribution  is  made  prefer- 
ably through  a  distributive  clearing  account.  Often  distribution 
of  all  such  costs  is  made  on  a  straight  percentage  basis,  and  often 
on  bases  which  apply  different  percentages  to  different  kinds  of 
cost.  The  methods  of  finding  a  fair  share  will  be  briefly  discussed 
in  Chapter  XXII.  Whatever  the  method,  however,  the  task  of 
transferring  many  separate  expense  accounts  to  many  separate 
department  accounts  is  much  simplified  by  transferring  net  ex- 
penses to  one  account  and  then  the  total  piecemeal  to  the  several 
departments,  rather  than  transferring  the  total  of  each  of  many 
expense  accounts  piecemeal  to  many  department  accounts.  An 
illustration  of  such  a  clearing  account  is  given  below. 

Space  Cost 


Rent 

15,000 

Department  A 

7,500 

Fuel 

2,000 

it 

B 

3,750 

Light 

1,200 

It 

C 

1,875 

Janitor  Wages 

2,500 

It 

D 

1,875 

Janitor  Supplies 

500 

tt 

E 

7,500 

Elevator  Power 

300 

Elevator  Wages 

1,000 

22,500 

22,500 

This  principle  may  be  applied  to  many  accounts,  recording  a  vast 
deal  of  statistical  information  without  destroying  or  confusing 
information  needed  for  the  balance  sheet. 

Clearing  Accounts  Real  or  Nominal.  It  will  have  been  noted 
that  clearing  accounts  gather  information  both  for  the  balance 
sheet  and  for  the  operating  statement.  Goods-in-Process  was 
debited  for  all  the  costs  involved  in  manufacturing,  was  credited 
for  those  that  needed  record  in  another  accoimt,  Finished  Goods, 
and  had  as  a  balance  the  value  of  goods  still  in  process;  so  it  is  a 
real  account.  Space  Cost,  on  the  other  hand,  is  used  only  at  time 
of  adjustment  of  the  books,  is  then  debited  only  for  things  that 
have  already  lost  their  identity  as  assets  under  the  names  used  for 
the  accounts,  and  is  credited  only  for  transfers  of  those  unreal 
(because  already  converted)  things  to  other  accounts;  so  it  is 
purely  nominal:  it  can  have  no  balance,  for  it  is  merely  a  transfer 
agent. 


136  THE  FUNDAMENTALS  OF  ACCOUNTING 

QUESTIONS  AND  PROBLEMS 

Asset  Accounts 

1.  In  what  account  or  accounts  should  you  carry  each  of  the  following 
assets  acquired  by  a  manufacturing  concern? 

(a)  Office  desks  and  chairs 

(b)  A  five-dollar  bill  found  in  a  cash  drawer 

(c)  A  note  of  John  Jones  bearing  interest  at  6%  dated  two  months  ago 

(d)  A  mortgage  note  received 

(e)  New  adding  machines 

(f)  Milling  machines 

(g)  Five  hundred  tons  of  coal 

(h)  Rent  paid  for  two  months  in  advance 
(i)  A  note  endorsed  by  you,  not  paid  at  maturity  (a  week  ago),  on 

which  you  have  received  no  notice  of  protest 
(j)  Bonds  set  aside  now  to  be  available  for  sale  when  we  wish  cash 

for  the  extension  of  activities  of  the  factory 
(k)  Finished  goods  claimed  by  a  customer  who  is  suing  you  for  their 

possession 
(1)  Real  estate  worth  $10,000  pledged  to  the  Employees'  Association 

on  condition  that  the  employees  subscribe  $10,000 
(m)  Accounts  receivable  three  years  old,  if  your  terms  are  60  days 

2.  Show  the  debits  and  the  credits  for  the  transactions  following.  (Assume 
interest,  if  not  otherwise  specified,  to  be  at  6%.) 

(a)  A  business  draws  a  sight  draft  for  $2,000  on  Dun  &  Angus  who 
owe  it  on  accounts  receivable  $2,000,  in  favor  of  Brown's  Sons  Co. 
from  whom  it  has  purchased  goods.    The  draft  is  paid. 

(b)  We  present  for  payment  a  note  for  $3,000  of  J.  Stone,  dated  nine 
months  ago,  bearing  interest  at  5%.  Stone  gives  us  in  exchange 
a  note  of  R.  Wood  due  to-day,  and  cash  for  the  interest  accrued 
on  his  own  note. 

(c)  We  pay  interest  $50  in  advance  to  S.  Marble  who  lends  us  for  two 
months  $5,000  at  6%. 

(d)  At  the  end  of  two  months  we  repay  S.  Marble's  loan. 

3.  Show  the  debits  and  the  credits  to  the  appropriate  accounts  for  the 
transactions  following. 

Jan.  I.  A  business  receives  in  payment  of  accounts  receivable  notes 
as  follows:  from  R.  Simpson  in  payment  of  his  bill  due  to-day  a  note 
for  $2,000,  payable  one  month  from  to-day  with  interest  @  6%;  from 
H.  Foote  for  his  bill  due  February  i  a  note  for  $1,000  payable  without 
interest  in  one  month;  from  R.  Gould  in  payment  of  his  bill  due  to-day 
a  note  for  $500,  payable  in  six  days  with  interest  @  6%. 

Jan.  7.  The  note  of  R.  Gould  is  presented  for  payment  but  is  not 
paid.  Simpson's  note  is  discounted  at  the  bank. 

Feb.  I.  Foote  pays  his  note.  Gould,  who  has  been  forced  into 
bankruptcy,  pays  fifty  cents  on  the  dollar  on  his  note  and  on  the  in- 
terest to  date.    Simpson's  note  is  paid. 


THE  CONTENT  OF  COMMON  ACCOUNTS  I37 

4.  (a)  The  Windham  Co.  discounts  at  its  bank  to-day  three  notes  dated 

to-day.  The  first  note  is  for  $1,000  due  in  one  month,  and  is  signed 
by  E.  C.  Seaman.  The  second  note,  signed  by  C.  E.  Waterman,  is 
for  $500  and  is  due  two  months  from  to-day.  The  third  is  a  note 
of  H.  Wilson  for  $2,000  due  one  month  from  to-day.  None  of  the 
notes  bears  interest. 
(b)  At  maturity  Wilson's  note  is  paid,  (c)  Seaman's  note  is  not  paid  at 
maturity  and  we  take  it  up.  We  have  hope  of  later  collecting  the 
amount,  (d)  Fifteen  days  later  the  principal  of  Seaman's  note 
is  paid,  but  no  interest  for  the  extended  loan  is  collected,  (e)  At 
maturity  Waterman's  note  is  presented  for  payment  but  is  not  paid. 
We  take  it  up.  (f)  After  waiting  a  month  longer  we  give  up  all 
hope  of  collecting  on  Waterman's  note. 

Assuming  interest  to  be  6%  show  the  entries  on  the  Windham 
Co.'s  books  for  all  the  transactions  in  which  the  notes  were  involved. 

Contra  Accounts 

5.  On  Jan.  i.  Real  Estate  has  a  balance  of  $20,000,  Machinery  of  $40,000, 
and  Equipment  of  $9,000.  On  June  30  the  books  are  brought  to  the 
time  and  depreciation  is  recorded.  The  real  estate  is  estimated  to 
have  depreciated  1%,  the  machinery  2%,  and  the  equipment  3%.  It 
is  desired  to  keep  the  real  estate  on  the  books  as  it  now  is,  in  order  to 
preserve  statistically  the  cost  of  the  property,  but  the  machinery  and 
equipment  accounts  are  desired  to  show  present  values. 

(a)  What  debits  and  credits  should  be  made  to  accomplish  this? 

(b)  If  on  July  i  the  depreciation  is  overcome  by  repairs  so  that  the 
property  is  in  the  same  condition  as  on  Jan.  i,  how  shall  you  record 
that  fact? 

6.  A  business  which  manufactures  high  explosives  sustains  on  the  average  of 
once  in  two  years  an  explosion  of  a  varying  degree  of  severity.  Because 
of  the  high  risk,  insurance  rates  are  prohibitive,  and  the  company  in- 
sures itself.  How  should  you  expect  it  to  do  this,  and  what  accounts 
should  you  debit  and  credit  for  the  provision?  What  should  you  debit 
and  credit  at  the  time  of  an  explosion? 

7.  A  mercantile  house  makes  a  monthly  provision  for  allowance  for  bad 
debts  which  it  figures  at  2%  of  its  Accounts  Receivable  balance  on  the 
last  day  of  each  month.  How  much  does  the  business  credit  to  Allow- 
ance for  Bad  Debts  in  each  of  the  months  involved  in  the  transactions 
given  below? 

On  January  i  the  books  show  a  balance  of  Accounts  Receivable  of 
$200,000  and  an  allowance  of  $4,000.  During  the  month  $1,000  of 
the  accounts  receivable  prove  bad  and  are  debited  to  the  allowance. 
The  balance  of  Accounts  Receivable  Jan.  31  is  $225,000.  During 
February  $2,000  of  Accounts  Receivable  prove  bad,  and  the  balance  of 
Accounts  Receivable  on  the  31st  is  $198,000.  During  March  no  debts 
prove  bad  —  the  balance  of  Accounts  Receivable  at  the  end  of  the 
month  is  $200,000.    In  April  $2,000  is  debited  to  the  allowance,  and 


138  THE  FUNDAMENTALS  OF  ACCOUNTING 

the  balance  of  Accounts  Receivable  on  the  30th  is  $230,000.  In  Ma> 
$400  of  Accounts  Receivable  prove  bad,  and  the  balance  at  the  end  of 
May  is  $210,000.  In  June  $200  of  Accounts  Receivable  is  found  bad, 
and  at  the  end  of  the  month  the  balance  is  $190,000. 

Ownership-Claim  Accounts 

8.  (a)  A  business  discounts  for  an  employee  a  non-interest  bearing  note 

of  Smith  &  Smith,  face  $1,000,  dated  one  month  ago  and  due 
IS  days  hence.  What  should  be  debited  and  what  credited? 

(b)  On  adjusting  its  books,  Dec.  31,^1921,  it  finds  that  it  has  outstand- 
ing the  following  notes  payable;  #648,  bearing  interest  at  6%  dated 
Dec.  1, 1921,  due  Feb.  i,  1922,  fpr  $500;  #649,  without  interest,  dated 
Nov.  30,  1921,  due  Jan.  30,  1922,  for  $1,000;  and  #652,  bearing  in- 
terest at  6%,  dated  Dec.  17,  192 1,  and  due  in  15  days,  for  $2,500. 
What  debits  and  credits  shall  it  make  to  bring  the  books  up  to  the 
time  with  respect  to  these  notes  (not  with  respect  to  the  proprietors' 
gain  or  loss  accounts)? 

(c)  The  note  of  Smith  &  Smith  mentioned  in  (a)  above  is  paid.  What 
is  debited  and  what  credited? 

(d)  You  lend  money  to  Arthur  Brown  on  his  note  for  $200  payable  in 
one  month.  He  pays  you  the  interest  in  cash  in  advance,  and  you 
give  him  a  check  for  $200.    What  debits  and  credits  should  be  made? 

9.  Interpret  as  far  as  you  can,  either  separately  or  in  conjunction,  the 
starred  items  on  the  following  balance  sheet  certified  as  in  accordance 
with  books  of  account  which  have  been  adjusted  to  date; 


Real  Estate* 

liS.ooo 

Partner  A  Capital 

I40.000 

Fixtures 

S.ooo 

Partner  B  Capital 

30/J00 

Merchandise 

S3 .000 

Mortgage  Notes  Payable* 

12,000 

Notes  Receivable* 

8,000 

Notes  Payable 

19.000 

Accounts  Receivable* 

87,000 

Notes  Discounted* 

4.000 

Bonds* 

io,soo 

Accounts  Payable 

56,000 

Cash 

4.S00 

Allowance  for  Depredation  of  Real  Estate 

3.000 

Allowance  for  Bad  Debts* 

S.000 

Surplus  Reserved  for  Mortgage  Payment* 

11,000 

Undivided  Profits* 

6,000 

$186,000 

$186,000 

10.  A  magazine  which  receives  one-,  two-,  and  three-year  subscriptions 
wishes  to  know  monthly  (a)  new  subscriptions,  (b)  current  expiration 
of  subscriptions,  (c)  liabiHty  on  subscriptions  unexpired  for  this  and 
for  each  of  the  years  for  which  subscriptions  have  been  received.  What 
accounts  should  the  magazine  keep  for  this  purpose? 

11.  The  following  three  provisions  are  made  in  the  agreement  of  a  partner- 
ship whose  fiscal  year  is  the  calendar  year. 

(i)  Partner  B  is  to  have  at  all  times  an  investment  equal  to  two- 
thirds  of  A's  investment;  in  case  of  default  B  shall  be  charged 
interest  @  6%  on  the  deficiency. 

(2)  Profits  are  to  be  shared  equally  and  credited  to  partners  annu- 
ally. Monthly  drawings  by  partners  may  be  made,  by  A  $700, 


THE  CONTENT  OF  COMMON  ACCOUNTS     1 39 

by  B  $500,  but  these  shall  be  deemed  to  be  anticipation  of 
profits,  and  shall  not  be  credited  to  partners  as  salaries. 
(3)  If  a  partner's  share  of  the  profits  for  the  year  is  insufiicient  to  cover 
his  drawings,  the  insufficiency  is  to  be  charged  to  his  capital  account 
unless  profits  of  the  previous  year  have  not  been  withdrawn. 
On  Dec.  i  A's  capital  account  has  a  balance  of  $30,000,  B's  capital 
account  of  $20,000.   A's  drawing  account  has  debits  of  $7,700,  B's 
drawing  account  has  debits  of  $5,500  and  credits  of  $2,000. 

What  accounts  should  you  debit  and  what  credit  to  record  the  fol- 
lowing: 
(i)  On  Dec.  10  A  withdraws  $6,000,  and  B  also  withdraws  $6,000.  (Is 
this  in  accordance  with  the  partnership  agreement?) 

(2)  On  Dec.  31  A  and  B  withdraw  their  monthly  allowances. 

(3)  The  profits  of  the  year  are  found  to  be  $13,000. 

(4)  B  withdraws  his  profits. 

Nominal  Accounts 

12.  Balances  are  found  on  a  ledger  as  follows.  List  separately  those  which 
are  debit  and  those  which  are  credit  balances.  (The  total  of  each  set 
of  balances  is  $141,550.) 

Notes  Receivable  Doubtful,  $1,000;  Provision  for  Fire  Hazard, 5i,QQo; 
Goods-in-Process,  $12,0001  Sales,  $Sijipo;  Cash,  $20,000;  Deprecia- 
tion, $^,000;  Supplies^  $250;  Insurance  Prepaid,  $s§2^  Leaseholds, 
$1,200;  Wages  Liability,  J500;  Power  Plant,  $2,000;  jTBrown,  Invest- 
ment, If^^xOep;  Petty  Cash,_$5o;  Repairs  Suspense,  $7|p;  Allowance 
for  Depreciation,  $2,000;  Mortgage  Notes  Payable,  $^3,000;  Debt  Loss 
Estimated,  ^^^^xj;  Mortgage  Notes  Receivable,  $3,o§;  Purchases, 
$35,000;  Stocks7$8^Qso;  Accounts  Payable,  $afljOQs>;  Machinery,  $10^000; 
Interest  Earned,  $3,050;  Discount  Given,  $2iO|  Rental  EarnedTli^ooo; 
Wages,  $ifl,QQo;  Allowance  for  Bad  Debts,  $1,000;  General  E^nenses, 
$5^000;  Notes  Payable,  $9,500;  Merchandise  Inventory,  $0,500;  Real 
Estate,  $12^000;  Raw  Material,  $^^550;  Bonds,  $4iOoo. 

13.  Show  the  debits  and  credits  under  each  of  the  two  assumptions  made  for 
the  transactions  discussed  in  the  paragraph  entitled  "Allowance  for 
Bad  Debts  Illustrated"  (p.  125),  and  show  a  rough  ledger  for  all  the 
accounts  concerned. 

14.  Show  debits  and  credits  for  the  following: 

(a)  An  allowance  is  made  at  the  close  of  the  year  for  estimated  bad  debts 
outstanding  in  Accounts  Receivable  on  sales  of  the  year,  $9,000. 

(b)  John  Doe,  a  customer  whose  account  for  $900  was  included  in 
Accounts  Receivable  at  the  close  of  the  year,  gives  us  a  note  for 
his  balance  with  interest,  $915. 

(c)  We  discount  Doe's  note  for  $900. 

(d)  Doe  fails  to  pay  his  note,  and  we  take  it  up  for  $915. 

(e)  We  write  off  this  indebtedness  to  us  against  the  allowance  for 
bad  debts  made  previously. 

(f)  Two  years  later,  John  Doe  pays  his  debt,  with  interest,  $1,025. 


140  THE  FUNDAMENTALS  OF  ACCOUNTING 

(g)  This  $1,025  gives  us  an  unexpected  margin  for  an  experiment  in 
advertising,  and  we  devote  $300  of  it  to  finishing  off  a  new  ad- 
vertising office  in  our  building,  $200  to  buying  equipment  for  it, 
and  the  rest  to  advertising  expense, 
(h)  The  experiment  proves  a  failure,  for  the  advertising  yields  vir- 
tually no  result. 
15.  From  the  following  information  about  purchases  and  sales  for  a  fiscal 
period  construct  what  you  can  of  an  operating  statement  and  show  the 
profit  on  sales.    Purchases  are  $4g;^»,ooo,=  returned  purchases,  $4QSQq^ 
discounts  taken,  $;^5po;  unexpired  discounts  available,  S^^oo^;  mer- 
chandise inventory  bfegmning,  $100,000;  merchandise  inventory  end, 
$150,000;  sales,  $35Q,^iQo;  returned  sales,  $10,000;  discounts  given, 
/Sjtooo:  unexpired  discounts  offered,  ^i^qoo.        ' 
iidfThe  following  were  the  ledger  balances  of  the  H.  Company,  Dec.  31,  '18: 

Capital  Stock  $100,000 

Accounts  Payable  20,000 

Notes  Payable  ^        10,000 

Cash  $  20,000 

Mdse.  Inventory,  1/1/18  20,000 

Purchases  120,000 

Sales  140,000 

Returned  Sales  1,000 

Real  Estate  40,000 

Interest  Charges  1,000 

Insurance  Prepaid  1,000 

Rental  Earned  1,000 

Commission  Charges  2,000 

Taxes  500 

Depreciation  1,000 

Allowance  for  Depredation  4>ooo 

Wages  12,500 

Surplus  4,000 

Accounts  Receivable  60,000 


$279,000      $279,000 

The  following  have  not  yet  been  adjusted  on  the  books :  interest  lia- 
bility, $500;  insurance  unexpired,  $600;  commission  earned,  $400;  wages 
liabiKty,  $1,500;  estimate  of  uncoUectibility  of  accounts  receivable, 
$2,000;  inventory  of  merchandise,  $30,000;  theft  from  the  warehouse 
on  the  night  of  December  31  after  the  inventory  had  been  taken,  $1,000. 

Construct  the  operating  statement  for  the  year  1918. 

Is  the  following  balance  sheet  consistent  with  your  income  sheet? 


Cash 

$20,000 

Capital  Stock 

$100,000 

Merchandise 

29,000 

Accounts  Payable 

20,000 

Accounts  Receivable 

58,000 

Notes  Payable 

10,000 

Real  Estate 

40,000 

Accrued  Liabilities 

2,000 

Insurance  Prepaid 

600 

Allowance  for  Depreciation 

4,000 

Commisj^ion  Accrued 

400 

Surplus 

12,000 

$148,000 

$148,000 

Heat 

Light 

Elevator  Service 

30% 

is7o 

40% 

IS 

2S 

10 

40 

3S 

30 

IS 

2S 

20 

THE  CONTENT  OF  COMMON  ACCOUNTS  I4I 

If  it  is  not  consistent,  why?  If  it  is,  explain  where  the  figure  for  sur- 
plus comes  from. 

Clearing  Accounts 

17.  Show  the  merchandise  clearing  account  for  the  transactions  in  Prob- 
lem 15,  above. 

18.  From  the  following  information  about  the  transactions  of  a  business, 
construct  clearing  accounts  for  merchandise,  for  trading,  and  for  in- 
come, and  the  proprietor's  drawing  account. 

Inventory,  Jan.  i,  1920,  $40,000;  Purchases,  $150,000;  Sales,  $187,000; 
Inventory,  Dec.  31,  1920,  $30,000;  Rent  Charges,  $3,000;  Wages, 
$10,000;  Insurance  Charges,  $300;  Depreciation,  $1,000;  Advertising, 
$2,000;  Losses  from  Bad  Debts,  $1,500;  General  Expenses,  $2,700; 
Dividends  on  Stocks  Owned,  $3,000. 

19.  Four  departments  of  a  store  bear  the  charges  for  heat,  light,  and  eleva- 
tor service,  in  the  following  percentages: 

Department  A 
Department  B 
Department  C 
Department  D 

ioo%        100%        100% 

Show  the  clearing  accounts  for  distributing  the  following  charges  to 
these  four  departments:  fuel,  total  cost  $3,000,  equally  divided  be- 
tween heat,  light,  and  elevators;  maintenance  of  heating  pipes,  radia- 
tors, etc.,  $300;  maintenance  of  lighting  wiring,  fixtures,  etc.,  $500; 
maintenance  of  elevators,  etc.,  $650;  wages  for  supervision  of  heating, 
$500,  for  supervision  of  Hghting,  $600,  for  elevator  service,  $4,500; 
power-plant  wages,  $2,800,  power-plant  maintenance,  $1,500,  power- 
plant  supplies,  $506,  the  last  three  to  be  divided  equally  between  heat, 
light,  and  elevators. 

20.  (a)  Why  cannot  Allowance  for  Discounts  Offered  have  a  debit  balance? 
(b)  At  the  end  of  a  period,  discounts  offered  to  customers  on  bills  sent 

out  but  not  yet  due  were  $1,300,  and  discounts  available  on  bills 
owed  by  the  firm  but  not  yet  due  were  $1,200.  During  the  next  six 
months  discounts  given  to  customers  amounted  to  $2,200,  of  which 
$800  were  on  bills  of  the  preceding  period  and  $1,400  were  on  new 
sales;  and  discounts  were  taken  by  the  firm  amounting  to  $3,500, 
of  which  $1,100  were  on  old  bills  and  $2,400  on  new.  Discounts 
offered  to  customers  in  the  six  months  were  $3,700,  of  which  $700 
are  on  bills  not  yet  collectible  even  under  the  most  favorable 
terms;  and  discounts  available  to  the  firm  within  that  period  were 
$5,600,  of  which  $3,000  are  on  bills  not  yet  due  even  under  the 
most  favorable  terms  offered  to  it.  Show  the  full  entries  sug- 
gested in  the  text  with  respect  to  discounts  for  (i)  closing  the  old 
books,  (2)  entering  the  transactions  of  the  six  months,  (3)  closing 
the  books  at  the  end  of  the  half  year. 


CHAPTER  DC 

THE  FUNDAMENTAL  PRINCIPLES  OF  BOOKKEEPING 
METHOD 

Original  Entries.  We  have  seen  that  some  device  is  necessary  for 
convenient  entry  to  the  many  accounts  affected  by  the  innumer- 
able transactions  of  modern  business.  Sometimes  a  single  trans- 
action needs  record  on  half-a-dozen  accounts  or  more,  and  if  any 
of  these  is  neglected  not  only  is  that  account  false  from  that  point 
on  but  the  general  scheme  of  things  is  upset.  A  method  is  needed 
that  not  only  will  assure  us  that  everything  required  for  any  ac- 
count actually  gets  carried  to  that  account,  but  will  enable  us  if 
anything  goes  wrong  to  trace  the  error  back  to  its  source.  Under 
adequate  bookkeeping  methods,  therefore,  no  items  are  entered 
directly  to  the  ledger  without  a  preliminary  record  of  some  sort  as 
a  basis  for  the  ledger  item.  These  preliminary  records  are  called 
** original  entries,''  and  the  items  in  the  ledger  are  called  ^'post- 
ings." The  original  entry  may  be  in  a  bound  book,  a  loose-leaf 
book,  or  in  a  document  kept  in  an  orderly  file;  but  it  must  be  avail- 
able for  reference  to  support  and  explain  the  posting  made  from 
it,  and  it  must  indicate  the  accounts  to  which  posting  was  made 
from  it.  The  posting,  too,  must  indicate  the  original  entry  from 
which  it  was  made.  The  posting,  or  ledger  item,  is  very  brief, 
usually  without  detail  or  explanation,  but  the  original  entry  is 
either  complete  in  detail  or  gives  references  to  records  or  docu- 
ments in  which  complete  details  may  be  found.  The  observ- 
ance of  this  is  important,  for  one  must  realize  that  the  ledger 
is  intended  to  give  summary  information  only,  totals  or  balances, 
whereas  for  many  business  transactions  great  detail  of  record  is 
necessary  and  should  not  be  scrimped.  Since,  too,  the  ledger 
brings  together  all  items  relating  to  one  aspect  of  the  business,  it 
serves  as  an  index  to  the  details  of  the  business;  for,  as  we  have 
seen,  each  ledger  item  shows  where  the  original  entry  can  be 
found.  In  other  words,  there  are  two  records  of  every  transac- 
tion, one  of  original  entry  in  detail,  with  a  reference  to  the  sum- 
mary record  so  that  we  can  trace  the  effect  of  the  transaction  into 


PRINCIPLES  OF  BOOKKEEPING  METHOD 


143 


the  total  and  the  balance  of  each  account  concerned,  and  the 
other  in  the  ledger,  affecting  the  balances  and  the  totals  of  the 
accounts  concerned,  with  a  reference  to  the  original  entry  from 
which  these  postings  were  made;  and  then  in  case  of  error,  or  sus- 
pected error,  it  is  possible  to  check  one  against  the  other  and  sat- 
isfy one's  seK  what  is  right. 

Ledger  Form.  Many  forms  of  ledger  are  in  use,  but  the  sim- 
plest and  most  common  has  the  page  divided  into  similar  halves, 
with  ruled  space  in  each  half  for  four  things:  date,  brief  explana- 
tion, reference  to  original  entry,  amount.  Thus,  if  on  April  29  we 
sold  Arthur  Gordon  some  goods  for  $100.00,  and  the  original  rec- 
ord was  on  page  24,  and  on  July  i  he  paid  $75.00  of  the  amount 
and  the  original  record  was  on  page  88,  the  ledger  for  his  account 
would  appear  as  follows: 

Arthur  E.  Gordon 


1920 

1920 

April  29 

Merchandise 

24 

100 

00 

July  I 

Cash 

88 

75 

00 


Here  is  full  summary  information  regarding  his  relations  with  the 
business,  with  full  reference  to  the  record  of  details.  If  one  is 
tempted  to  ask  why  the  details  are  not  shown  here,  thus  eliminat- 
ing the  need  of  the  original  entries,  a  sufficient  answer  is  that  al- 
ways a  transaction  involves  two  accounts,  as  we  have  seen,  and 
often  moie  than  two,  and  that,  therefore,  the  plan  of  posting  de- 
tails into  the  ledger  would  involve  writing  them  at  least  twice, 
whereas  by  this  method  one  writing  of  details  serves  all  pur- 
poses, however  many  may  be  the  accounts  concerned.  Manj 
bookkeepers  do  not  use  the  explanation  column  at  all.  A  con- 
venient method,  which  makes  little  work  and  gives  much  informa- 
tion, is  to  use  for  explanation  the  name  of  the  *' other  account" 
concerned  in  the  transaction,  that  is,  of  the  account  credited  when 
this  account  was  debited,  or  vice  versa.  Usually  all  transactions 
on  the  same  side  are  similar,  and  hence  after  an  account  is  started 
ditto  marks  serve  for  explanation  of  most  items,  but  exceptional 
items  (and  those  are  most  likely  to  need  later  reference)  will  stand 
out  conspicuously  as  they  should.  That  is  the  form  of  ledger 
used  chiefly  in  this  book,  though  other  forms  will  be  referred  to 
later.    As  much  space  will  be  provided  for  each  accoimt  as  the 


144  THE  FUNDAMENTALS  OF  ACCOUNTING 

bookkeeper  estimates  is  necessary  to  accommodate  the  probable 
postings  for  a  long  period,  a  page,  half  a  page,  or  what  not. 

Ledger  Balances.  We  have  already  observed  that  for  our  bal- 
ance sheet  we  wish  to  use  ledger  balances,  or  net  figures,  and  for 
statistical  information  we  may  wish  to  use  ledger  totals.  When 
we  desire  totals,  however,  we  usually  wish  them  for  a  definite 
period  and  we  wish  to  exclude  totals  of  earlier  periods.  We  need 
a  device,  then,  that  will  enable  us  to  get  easily  both  totals  for  any 
period  and  balances  as  of  any  day.  This  is  supplied  by  the  com- 
mon method  of  *' balancing"  an  account.  To  ''balance  an  ac- 
count" is  to  show  on  the  account  itself  as  a  specific  figure  the  bal- 
ance at  the  time  of  balancing,  or  to  show  that  the  account  has  no 
balance  at  that  time.  The  method  is  not  subtraction  but  addition ; 
it  consists  not  in  subtracting  the  smaller  side  from  the  larger,  for 
we  do  not  wish  to  mingle  subtractions  and  additions  on  our  ledger, 
but  to  add  to  the  smaller  side  enough  to  make  it  equal  to  the 
larger,  and  in  that  way  indicate  how  much  larger  is  the  larger  side. 
The  method  is  like  that  commonly  used  in  "counting  change"; 
in  counting  out  the  change  to  give  a  customer  who  has  rendered  a 
dollar  bill  for  a  purchase  of  sixty-one  cents,  the  cashier  does  not 
subtract  sixty-one  from  one  hundred  and  then  count  out  thirty- 
nine;  she  adds  to  sixty-one  enough  to  make  one  hundred,  as  four 
to  sixty-one  to  make  sixty-five,  ten  more  to  make  seventy-five, 
and  then  twenty-five  more  to  make  one  hundred,  though  she  may 
prove  her  work  by  subtracting  and  seeing  that  the  change  equals 
the  difference.  So  in  balancing  an  account,  say  Cash,  if  the  credit 
side  is  $615.94,  and  the  debit  side  is  $718.99,  $103.05  is  entered 
on  the  credit  side  to  make  that  side  as  large  as  the  debit,  and  that 
item  preserves  the  balance  as  of  the  day  of  balancing.  This,  how- 
ever, is  obviously  not  all  that  is  to  be  done,  for  the  account  is  now 
not  indicative  of  the  status  of  this  aspect  of  the  business  unless 
we  have  clear  indication  that  the  balancing  item  of  $103.05  is  not 
a  new  item  but  is  only  another  expression  for  the  items  already  on 
the  ledger  —  that  is,  that  it  expresses  in  final  summary,  or  net 
result,  all  that  the  other  figures  have  already  expressed.  We 
must  make  clear  that  the  account  is  not  now  without  balance,  as 
it  appears  to  be  with  debits  and  credits  equal,  but  has  a  balance 
of  $103.0$,  and  we  must  make  sure  that  this  amount  not  only  gets 


PRINCIPLES  OF  BOOKKEEPING  METHOD  I45 

upon  our  balance  sheet  but  goes  down  on  the  ledger  to  the  next 
period  as  the  opening  figure  inherited  from  the  old  period.  We 
may  also  wish  to  preserve  the  total  figure  of  the  old  period.  We 
can  accomplish  both  of  these  ends  by  the  simple  device  of  show- 
ing the  total  of  both  sides  of  the  account  directly  on  our  ledger, 
and  then  repeating  the  balance  below  on  the  side  where  it  belongs, 
as  the  first  item  of  the  new  period,  thus: 

Cash 
718.99  615.94 
Balance    103.05 

71899  718.99 

Balance  103.05 

It  will  be  observed  that  the  first  writing  of  the  balance  is  on  the 
side  where  it  does  not  belong,  for  the  purpose  is  to  show  how  much 
is  necessary  to  add  to  that  side  to  make  it  equal  the  other;  that 
the  total  is  then  taken  to  show  that  the  figuring  of  the  balance  is 
correct,  and  to  give  the  statistical  figure  of  the  total  volume  of 
business  in  this  respect;  that  the  total  is  entered  on  the  same  line 
on  both  sides,  to  show  a  fresh  start  on  both  sides  at  the  same  point; 
and  lastly  that  the  balance  is  brought  down,  below  the  total,  on 
the  side  which  is  in  excess,  where,  of  course,  it  belongs  as  the 
opening  item  for  the  new  period.  The  closing  balance  (that  is, 
the  item  inserted  on  the  smaller  side)  is  commonly  written  in  red 
ink  to  distinguish  it  from  postings  or  original  items,  for,  as  we 
have  seen,  this  is  not  a  new  item  but  a  summary  of  old  items  al- 
ready on  the  books;  but  the  opening  balance  brought  down  to  the 
new  period  of  course  has  full  validity  now  that  it  wholly  supplants 
the  old  items  by  starting  a  new  period,  and  hence  should  not  be 
distinguished  from  other  items  except  by  indication  that  it  is  a 
summary  of  old  items,  as  is  done  by  the  word  "balance."  The 
ruling  just  shown  is  typical.  A  single  horizontal  ruled  line  in- 
dicates that  an  addition  or  a  subtraction  is  performed  at  this 
point  (though  in  ledgers  subtractions  are  not  performed),  and  a 
double  horizontal  ruled  line  indicates  that  the  process  goes  no 
farther  (usually  because  equality  is  attained  at  that  point)  — 
though  the  process  may  be  started  afresh  below.  Here,  for  in- 
stance, the  single  horizontal  line  shows  that  the  total  of  the 
period  is  now  taken,  and  the  double  line  shows  that  a  new  period 


146  THE  FUNDAMENTALS  OF  ACCOUNTING 

begins  here  and  hence  addition  will  never  again  go  above  this 
point.  If  one  wished  the  total  of  several  periods  for  a  statistical 
figure,  one  would  take  the  sum  of  totals  for  those  periods  and  dis- 
regard individual  items.  Balancing  may  be  done  whenever  con- 
venient, of  course;  but  when  statistical  figures  of  totals  for  defi- 
nite periods  are  desired,  convenience  may  require  that  balancing 
be  not  done  except  at  the  end  of  each  period. 

Form  of  Original  Entries.  Posting  (entering  in  the  ledger) 
from  original  entries  is  an  important  part  of  a  bookkeeper's  work, 
for  final  conclusions  about  the  business  are  always  drawn  from 
figures  of  totals  or  balances,  and  as  these  are  taken  from  the 
ledger  the  postings  should  be  absolutely  accurate.  The  task  of 
the  bookkeeper  in  making  postings  must,  therefore,  be  made  as 
easy  as  possible,  else  errors  will  creep  in.  Indeed,  posting  should 
be  made  automatic  and  mechanical  as  far  as  possible.  If  thought 
and  analysis  and  careful  record  are  given  in  original  entries,  no 
need  remains  for  anything  but  speed  and  accuracy  in  posting. 
Hence  the  original  entry  should  be  so  arranged  that  the  book- 
keeper can  see  at  a  glance  just  what  is  to  be  posted,  and  to  what 
accounts  posting  is  to  be  made.  Except  that  the  record  must  be 
expressed  clearly  enough  to  be  intelligible  to  a  competent  reader, 
this  is  the  only  requirement  of  original-entry  form.  The  simplest 
form  of  record  is  that  of  a  diary,  or  day  book,  in  which  the  trans- 
action is  described  with  all  the  detail  that  any  one  is  likely  ever 
to  wish  to  know  about  it,  such  as  quantities,  rates,  number  of 
freight  car  in  which  shipment  was  made,  persons  concerned,  etc. 
To  post  from  such  a  record,  however,  picking  out  the  amount  to 
be  posted  to  each  of  various  accounts  and  making  sure  not  only 
that  none  is  forgotten  and  none  is  posted  twice  but  also  that  all 
intended  to  be  posted  are  actually  posted,  is  difficult.  A  device 
for  Usting  all  items  to  be  posted,  with  the  names  of  the  accounts 
and  the  amounts,  and  a  provision  for  checking  the  items  when 
posting  is  completed,  becomes  almost  a  necessity  —  at  least  if 
one  is  to  work  rapidly  and  trace  errors  when  they  occur,  as  they 
do  occasionally  in  every  office.  The  time  spent  in  listing  the 
postings  to  be  made  and  checking  the  items  on  the  list  when  made 
is  far  less  than  the  time  that  would  be  required  to  analyze  the 
record  again  if  any  question  should  arise  and  to  hunt  for  omitted 


PRINCIPLES  OF  BOOKKEEPING  METHOD  I47 

postings  and  find  duplicated  postings  if  no  check  list  were  kept. 
Accordingly  every  record  in  a  book  of  original  entry  has  provision 
for  such  a  check  list,  which  is  usually  called  the  ''journalization." 

Journalization.  Suppose,  for  example,  a  partner  comes  into  a 
business  and  as  his  contribution  to  its  capital  transfers  to  it  a 
building  worth  $50,000.  The  diary  or  day-book  portion  of  the 
entry  would  read  somewhat  as  follows: 

April  I,  1923 

James  Mimroe  entered  the  firm  to-day  as  a  partner,  under  the  co- 
partnership agreement  of  this  date,  investing  real  estate  of  a  value  of 
$50,000,  as  per  deed  recorded  at  the  office  of  the  Register  of  Deeds, 
Middlesex  County,  Volume  615,  Folio  271. 

The  journalization  would  usually  be  written  in  direct  connection 
with  the  diary  record,  either  above  it,  below  it,  or  alongside  it,  in 
form  somewhat  like  this: 

I        I       Real  Estate    '  I        50,000         1  I 

I        I         To  James  Munroe  |  |        50,000        | 

The  Journal.  When  the  detailed  portion  of  the  entry  and  the 
journalization  are  combined  in  this  fashion,  the  book  of  original 
entiy  is  usually  called  the  "journal."  The  amounts  debited  are 
usually  written  in  the  left  column,  and  the  amounts  credited  in 
the  right.  The  account  or  accounts  to  be  debited  are  usually 
named  first,  followed  by  the  names  of  any  accounts  to  be  credited; 
these  last  are  usually  indented  and  are  often  prefixed  by  *' To"  as 
a  special  indication  of  the  fact  that  each  item  is  a  credit.  This 
arrangement  is  not  necessary,  however,  for  great  flexibility  is 
found.  Any  other  form  will  do  if  it  is  convenient  for  rapid  and 
accurate  posting,  and  this  means  that  it  must  clearly  show  three 
things:  what  accounts  are  to  have  postings,  what  amounts  are  to 
be  posted  to  each,  and  whether  the  postings  are  to  be  debits  or 
credits.  As  we  go  on  to  labor-saving  devices,  we  shall  see  that 
innumerable  variations  of  this  form  are  not  only  acceptable  but 
desirable.  The  form  given  above  is  simply  the  standard  form 
requiring  no  labels  on  any  item,  whereas  variations  from  this  form 
may  require  labels  attached  to  each  item  so  that  the  bookkeeper 
may  not  become  confused.  The  colunm  before  the  names  of  the 
accounts  is  for  the  posting  check,  to  indicate  that  the  posting  has 
or  has  not  actually  been  made.    Commonly  the  ledger  page  num- 


148  THE  FUNDAMENTALS  OF  ACCOUNTING 

ber  of  the  account  to  which  posting  is  made  is  used  as  a  check 
mark  (and  the  column  is  called  the  ''ledger-folio"  column  [L.F.]) 
—  and  it  must  never  be  checked  until  the  posting  has  actually  been 
made,  as  interruption  of  the  bookkeeper  just  prior  to  posting  may 
cause  the  item  to  be  omitted  altogether  from  the  ledger. 

Complete  Record.  The  three  records  so  far  discussed  give  us  a 
complete  bookkeeping  story,  and  no  variations  can  satisfactorily 
do  less  than  this,  nor  can  they  do  more  —  except  to  give  auxiliary 
information  of  a  statistical  nature  not  contemplated  usually  under 
the  head  of  bookkeeping.  We  have  either  the  full  detailed  story 
or  a  reference  to  a  documentary  record  in  the  original  entry;  we 
have  a  summary  of  it  in  journalization  form,  with  indication  of 
just  what  amounts  have  been  posted  to  each  account  concerned; 
and  in  the  ledger  we  have  the  transaction  split  up  into  its  parts, 
so  to  speak,  and  each  part  carried  to  a  new  place  where  it  will  join 
other  similar  parts  from  other  transactions  and  show  the  net  effect 
and  the  total  effect  of  all  such  parts  on  each  particular  phase  or 
aspect  of  the  business.  In  the  books  of  original  entry  transac- 
tions are  recorded  chronologically  and  the  parts  are  kept  together 
as  units  or  entities,  and  each  transaction  is  recorded  without  re- 
lation to  any  other  transaction;  but  in  the  ledger  the  parts  of 
each  transaction  are  distributed  and  placed  not  with  other  parts 
of  the  same  transaction,  but  with  the  parts  of  other  transactions 
that  have  to  deal  with  the  same  general  phase  or  aspect  of  the 
business.  If  twenty  transactions  have  to  do  with  purchases  for 
cash  and  twenty  with  sales  on  account,  forty  original  records 
will  be  required  as  forty  entities  on  the  books  of  original  entry; 
but  on  the  ledger  only  three  accounts  will  be  concerned.  Cash, 
Merchandise,  and  Accounts  Receivable,  and  the  postings  to  these 
three  accounts  will  cover  the  whole  ledger  story.  There  will  be 
twenty  debits  to  Merchandise,  twenty  credits  to  Merchandise, 
twenty  credits  to  Cash,  and  twenty  debits  to  Accounts  Receivable. 
In  other  words,  the  original  entry  makes  a  unit  of  classiJ&cation  of 
each  transaction,  but  the  ledger  makes  a  unit  of  classification  of 
each  phase  or  aspect  of  the  business;  and  the  original  entries  may 
have  many  units  while  the  ledger  has  few,  or  the  original  entries 
may  have  few  while  the  ledger  (if  the  original  entries  involve 
many  varying  parts)  may  have  many.     In  any  case,  however, 


PRINCIPLES  OF  BOOKKEEPING  METHOD 


149 


the  same  facts  are  recorded,  and  the  difference  lies  in  the  arrange- 
ment or  grouping  of  items. 

The  Entry.  Heretofore  the  word  "entry"  has  been  used  with- 
out definite  statement  of  meaning,  as  if  it  indicated  merely  "  rec- 
ord.'^  Properly,  however,  it  should  always  contemplate  a  com- 
plete record,  which  embraces  full  explanation  and  all  necessary 
debits  and  credits  for  any  transaction;  and  hence  neither  a  debit 
nor  a  credit  can  be  an  entry,  for  an  entry  always  involves  an  equa- 
tion of  debits  and  credits.  Since,  however,  the  detailed  diary 
portion  of  an  entry  does  not  usually  give  rise  to  any  difference  of 
opinion  or  involve  accounting  difficulties,  the  term  "entry"  as 
we  shall  use  it  hereafter  in  this  book  will  usually  refer  to  the 
journalization  portion  of  the  entry,  or  the  statement  of  accounts 
to  be  debited  and  those  to  be  credited,  with  their  respective 
amounts.  The  word  "entry"  is  sometimes  carelessly  used  for 
"posting" ;  but  it  is  obvious  that  a  posting  cannot  be  an  entry,  for 
it  takes  at  least  one  debit  and  one  credit  to  make  an  entry,  and 
a  posting  can  never  be  both  of  these  at  the  same  time,  for,  as 
indicated  above,  a  posting  is  only  one  part  of  an  entry  purposely 
spht  off  from  the  other  parts  so  as  to  be  separately  posted  in  the 
ledger  under  a  new  unit  of  classification. 

Illustrations.  Now  let  us  observe  a  number  of  entries  and  the 
posting  of  their  elements.  We  will  use  for  illustration  the  trans- 
actions given  in  Chapter  VII  and  make  full  record,  using  the  form 
of  journal  which  puts  the  journalization  above  the  explanation  or 
diary  (day-book)  portion  of  the  entry,  and  showing  the  ledger  at 
the  end,  pages  151-152.  We  shall  use  Loss  and  Gain  instead  of 
Converted  Assets  for  determining  our  profit  at  the  end. 


JOURNAL 

July  I,  1923 


[page  18] 


Cash 

To  John  Smith,  Capital 
John  Smith  has  begim  business  to-day  with  a  cash 

investment  of  $8,000 

2 
Raw  Material 

To  Cash 
As  per  invoices  ##1-7  inclusive 


8,000 

00 

8,000 

00 

S,ooo 

00 

S,ooo 

00 

13,000 

00 

13,000 

00 

ISO 


THE  FUNDAMENTALS  OF  ACCOUNTING 


JOURNAL  (coniinued) 
6 


[page  19] 


Wages 

To  Cash 
Pay  roll  #1 

8 
Insurance  Prepaid 

To  Cash 
Policy  #151,298 

Fuel 

To  Cash 
Invoice  #8 

9 

Rent 
To  Cash 

For  month  of  July 

10 

General  Expenses^ 
To  Cash 

Reimbursement  to  J.  S.  for  sundry  payments  made 
by  him,  all  chargeable  to  general  expense. 
20 

Royalties 
To  Royalty  Liability 

Royalty  accrued  on  use  of  machines,  payable  Au- 
gust IS 

25 
Accounts  Receivable 

To  Sales 
Sales  to  date,  per  Sales  Book 

31 
Loss  &  Gain 
To  Raw  Material 

Wages 

Insurance  Prepaid 

Fuel 

Rent 

General  Expenses 

Royalties 
To  transfer  all  costs  for  the  month  to  Loss  &  Gain 

Goods-in-Process 
Finished  Goods 

To  Loss  &  Gain 
To  credit  the  latter  accoxmt  for  inventories 

Sales 

To  Loss  &  Gain 
To  transfer  sales 

Loss  &  Gain 

To  John  Smith,  Personal 
To  transfer  profit  to  proprietor 


1,400 

00 

1,400 

00 

300 

00 

300 

00 

350 

00 

350 

00 

200 

00 

200 

00 

450 

00 

4SO 

00 

230 

00 

280 

00 

1,700 

00 

1,700 

00 

4,005 

00 

1,500 

00 

1,400 

00 

75 

00 

100 

00 

200 

00 

4SO 

00 

280 

00 

'  2,205 

00 

600 

00 

2,805 

00 

1,700 

00 

1,700 

00 

Soo 

00 

SOO 

00 

13,090 

00 

13^690 

00 

PRINCIPLES  OF  BOOKKEEPING  METHOD 


iSi 


July   1 


John  Smith 


Aug.  I 

Balance 

July   2 

Cash 

Aug.  I 

Balance 

July   6 

Cash 

July   8 

Cash 

Aug.  I 

Balance 

July   8 

Cash 

Aug.  I 

Balance 

July   0 

Cash 

Julyio 

Cash 

LEDGER 

John  Smith,  Capital 
I        III  July    I  I   Cash 

John  Smith,  Personal 

I        III  July  31  I  Loss  &  Gain 

Cash 

Raw  Material 

Wages 

Insurance  Prepaid 

Fuel 

Rent 

General  Expenses 

Balance 


i8 

8ooo 

oo 

July    2 
6 
8 
8 
9 

lO 

Sooo 

GO 

300 

OO 

Raw  Material 


i8 

S.ooo 

oo 

oo 

July  31 

5.000 

3,Soo 

oo 

Loss&  Gain 
Balance 


ig 


Wages 
i,4oo[oo    III  July  31  I  Loss  &  Gain 


Insurance  Prepaid 


300 

00 

July.'ai 

300 

00 

22s 

00 

Fuel 


19 

3SO 

00      f 

July  31 

350 

00 

2SO 

00 

Loss  &  Gdn 
Balance 


Loss  &  Gain 
Balance 


19 


19 


Rent 
200I00    III  July  31  I  Loss  &  Gain 


General  Expenses 

4So|oo    III  July  31  I  Loss  &  Gain 


Royalties 
July  20  I  Royalty  Liability  I  19  ||      28o|oo    |||  July  31  j  Loss  &  Gain 

Royalty  Liability 
I  I      II         I       III  ^"^^  ^°  I  ^°y*^*^* 

Accounts  Receivable 
.Tttly  25  I  Sales  j  19  Ij  xjoojoo    j|j '  j 


I  "11 


"7 


[page  I 

8,ooo|oo 

[page  2 

Sooloo 

[pages 

s.ooo 
1,400 

300 

3  so 

200 

4SO 

300 


8,000 


[page  4 


3.50000 


5,000  00 


[page  s 


19  II    i,40o|oo 


[page  6 


'^ 


7 


19 


19 


19 


[page  7 

100  00 
250  00 


[page  8 

200|00 


[page  9 

450I00 


[page  10 

280I00 


[page  II 

2So|oO 

[page  12 


152 


THE  FUNDAMENTALS  OF  ACCOUNTING 


July  31  I  Loss  &  Gain 


July  31  I  Loss  &  Gain 


July  31  I  Loss  &  Gain 


July  31     Sundries 
uly  31     J.  S.,  Personal 


LEDGER  (continued) 

Sales  [page  13 

I  19  [I   i,7oo|oo    III  July  2S  I  Accounts  Receivable  I  19  11    i.7oo[oo 

[page  14 

I    II     I 

[page  IS 


Goods-in-Process 

19   II     2,20S|00      III  I 


19 


Finished  Goods 

II  "-^^  III       I 

Loss  &  Gain 


19 
19 

*TJ> 

00 
00 

July  31 
July  31 

4,505 

00 

Sundries 
Sales 


[page  16 

2,80s  loo 


If  we  now  take  our  balance  sheet  we  get  the  following,  which, 
it  will  be  observed,  has  identical  items  with  that  on  page  61 .  The 
order  in  which  the  items  appear  is  somewhat  different,  because 
we  have  here  followed  the  inventory  method  whereas  the  other 
was  obtained  by  the  cost-accounting  method,  and  hence  the  order 
of  entries  was  somewhat  different,  and  in  neither  case  have  we 
attempted  to  rearrange  our  items  in  any  way  but  have  left  them 
as  they  chanced  to  come  from  the  entries. 


Balance  Sheet 

Cash 

$  300.00 

John  Smith  (Capital) 

$8000.00 

Raw  Material 

3500.00 

John  Smith  (Personal) 

500.00 

Insurance  Prepaid 

225.00 

Royalty  Liability 

280.00 

Fuel 

250.00 

Accounts  Receivable 

1700.00 

Goods-in-Process 

2205.00 

Finished  Goods 

600.00 

$8780.00 

' 

$8780.00 

Correcting  Errors.  Since  original  entries  are,  next  to  original 
documents,  the  best  evidence  of  a  transaction,  care  should  be 
taken  not  to  invalidate  that  evidence  by  erasures;  for  no  one 
knows  what  was  erased,  and  hence  no  one  can  tell  whether  the 
change  was  innocent  or  fraudulent.  An  original  entry  should 
never  be  erased  in  a  vital  part,  i.e.,  names,  numbers,  items, 
amounts;  but  of  course  posting-check  numbers,  etc.,  when  only 
one  could  possibly  be  correct,  are  not  vital.    The  means  of  cor- 


PRINCIPLES  OF  BOOKKEEPING  METHOD  153 

reeling  an  error  is  either  (i)  cancelling  the  original  entry  and 
making  a  new  correct  entry,  or  (2)  making  a  "correction  entry" 
which  when  taken  in  connection  with  the  original  entry  will  pro- 
duce the  correct  net  result.  In  simple  bookkeeping  such  as  is 
described  in  this  chapter  the  cancellation  method  is  convenient; 
but  in  most  modem  bookkeeping  practice  entries  are  not  usually 
in  such  simple  form,  and  either  or  both  the  debit  and  the  credit 
are  combined  with  other  entries  in  many  totals,  by  methods  soon 
to  be  described:  then  cancellation  is  awkward,  and  making  a 
correction  entry  is  preferable.  The  method  to  be  followed  will 
depend  on  circumstances.  If  the  error  is  found  before  the  item 
has  been  carried  farther  (combined  with  other  entries,  or  posted) 
and  is  merely  clerical  in  nature,  like  extending  a  wrong  figure,  the 
proper  thing  to  do  is  to  cancel  the  wrong  item  by  drawing  a  line 
through  it  (preferably  a  waving  line  so  that  it  will  not  stand  out 
conspicuously  on  the  page)  and  to  insert  the  correct  item  above 
it.  Even  though,  too,  the  item  has  already  been  posted,  if  it  is 
posted  without  complication  with  other  entries  simple  substitu- 
tion on  both  the  journal  and  the  ledger  of  the  right  item  for  the 
wrong  is  adequate.  When  any  correction  entry  is  made,  the 
original  entry  should  be  clearly  marked  "erroneous,"  with  an 
indication  of  where  the  correction  will  be  found,  and  the  cor- 
rection should  clearly  state  of  what  it  is  a  correction. 

Correction  Entries.  If  we  find  that  in  charging  a  customer  we 
have  omitted  some  item,  we  can  correct  the  error  by  making  a 
new  charge.  If  the  error  was  in  overcharging,  we  correct  it  by 
debiting  Sales  and  crediting  the  customer.  If  we  charged  Smith 
when  we  should  have  charged  Brown,  we  correct  the  error  by  now 
debiting  Brown  and  crediting  Smith.  If  we  debited  Cash  when 
we  should  have  debited  Notes  Receivable,  we  now  debit  Notes 
Receivable  and  credit  Cash.  Every  error  is  capable  of  correction 
by  another  entry.  It  should  be  clearly  understood,  however,  that 
when  a  correction  entry  is  made  the  old  entry  remains  and  the 
new  entry  is  added  to  it;  whereas  by  the  cancellation  method  the 
new  items  are  substituted  for  the  old.  Great  care  should  be  taken 
in  making  correction  entries,  for  since  they  represent  not  actual 
transactions  which  to  an  experienced  person  automatically  sug- 
gest the  entries,  but  purely  arbitrary  mathematical  changes,  care- 


TS4 


THE  FUNDAMENTALS  OF  ACCOUNTING 


lessness  may  escape  detection.  Subordinate  bookkeepers  should 
not  make  correction  entries  without  the  approval  of  their  su- 
periors. 

Loose-Leaf  Books.  The  books  described  are  not  essentially 
different  whether  permanently  bound  or  in  loose-leaf  form.  The 
loose-leaf  form  makes  possible  the  transfer  to  a  file  of  all  inactive 
records,  thus  reducing  the  bulk  to  be  handled  currently.  Cards 
substituted  for  any  type  of  book  serve  the  same  purpose.  The 
limitations  on  the  usefulness  of  these  devices  are  the  awkwardness 
of  having  records  scattered,  and  the  danger  of  forgery  by  substi- 
tution of  a  faked  for  a  genuine  ''original  entry."  Further  com- 
ment on  the  latter  is  made  at  the  end  of  Chapter  XI. 


QUESTIONS  AND  PROBLEMS 
I.  The  following  account  is  found  on  the  ledger  of  a  business. 

Cash 
1920   I 
July  1 1  Sundries 


286      soolio 


How  should  you  proceed  to  get  full  information  about  the  meaning  of 
the  item? 
2.  What  information  does  the  following  ledger  account  give? 

Supplies 


1920 

1920 

Jan.  I 

Balance 

s/ 

ISO 

00 

June  31 

Feb.  I 

Cash 

10 

50 

00 

Mar.  I 

(( 

12 

100 

00 

Apr.  I 

Sundries 

16 

300 

00 

June  I 

Cash 

18 

25 
625 

00 

00 

July  I 

Balance 

^ 

125 

00 

Converted  Assets 
Balance 


500 

I2S 


625 


If  you  were  to  lose  the  merchandise  account  from  a  loose-leaf  ledger,  how 
should  you  reconstruct  it?  How  should  you  test  the  accuracy  of  your 
work? 

On  March  i,  1920,  Brown  and  Green  enter  into  a  partnership  agreement 
under  the  terms  of  which  they  are  to  share  all  profits  and  losses  equally. 
Brown  invests  $10,000  in  cash;  and  Green  invests  $2,000  in  cash,  and  a 
$5,000  note  of  the  National  Oil  Company  due  that  day  and  not  bear- 
ing interest,  and  $3,000  in  X  and  Y  stocks. 

Mar.  I.  The  partners  rent  a  store  from  The  Realty  Company  for  one 
month  for  $200,  and  pay  the  rent  in  cash.  The  note  of  the  National 
Oil  Company  is  paid.    Merchandise  is  purchased  from  Jones  &  Co.  for 


PRINCIPLES  OF  BOOKKEEPING  METHOD  155 

$10,000;  $5,000  is  paid  on  account.  Equipment  is  bought  for  cash, 
$500,  and  fittings  are  bought  for  cash,  $1,000  —  both  from  Jordan 
&Co. 

Mar.  2.  Merchandise  is  sold  for  cash  to  Smith  Brothers,  $2,000. 
Supplies  are  bought  for  cash,  $75. 

Mar.  4.  Merchandise  is  sold  on  account,  to  J.  Taylor,  $5,000;  for 
cash,  $2,000.    Postage  and  stationery  are  bought,  $100. 

Mar.  6.  Merchandise  is  bought  from  Stevens  &  Son  on  account, 
$10,000.  $5,000  is  paid  on  the  purchase  of  March  i.  An  express  bill 
for  $70  is  paid  to  the  National  Express  Co. 

Make  entries  for  the  above  transactions  and  post  them  to  the  ledger. 
In  view  of  the  fact  that  entries  are  few,  use  an  old-fashioned  mixed 
account  for  merchandise.  [The  total  debits  and  the  total  credits  both  in 
the  journal  and  in  the  ledger  are  $65,945.] 

5.  Brown  &  Green,  proprietors  of  the  business  of  Problem  4,  decide  to 
admit  White  to  the  partnership,  and  therefore  it  is  necessary  to  bring 
the  books  up  to  the  time  to  show  the  status  of  the  business. 

The  bookkeeper  finds  that  two  errors  have  been  made.  The  equip- 
ment bought  on  March  I  was  really  purchased  from  Marsh  Bros.,  for 
Jordan  &  Co.  were  only  agents.  On  March  4  merchandise  recorded 
as  sold  on  account  was  later  in  the  day  paid  for  by  a  note  (payable 
on  demand).     Correct  these  errors. 

The  inventory  of  merchandise  is  $13,000;  one-fourth  of  the  rent  has 
expired;  $75  worth  of  stationery  and  postage  is  on  hand;  $50  worth  of 
supplies  are  on  hand,  but  in  addition  to  those  originally  purchased 
$50  worth  have  been  bought  and  received,  but  have  not  yet  been  paid 
for  or  been  entered  on  the  books. 

Balance  the  ledger  preparatory  to  White's  admission,  and  draw  up  a 
balance  sheet. 

6.  On  May  i  the  balance  sheet  of  Johns  &  Peters  was  as  shown  below: 


Fixtures 

$  2,000 

J.  Johns 

$15,000 

Merchandise  Inventory 

17,000 

P.  Peters 

10,000 

Accounts  Receivable 

23,500 

Notes  Payable 

5,000 

Supplies 

200 

Accounts  Payable 

15,000 

Commission  Accrued 

700 

Rent  Liability 

200 

Cash 

1,800 

$45,200 

$45,200 

Set  up  the  ledger  from  which  this  balance  sheet  was  drawn.  For  the 
following  transactions  of  the  first  four  days  of  May  make  the  original 
entries,  post,  list  the  ledger  totals  of  each  account,  and  then  add  all 
ledger  totals  together  and  see  that  the  debits  equal  the  credits.  Use  sep- 
arate accounts  for  purchases,  sales,  returned  purchases,  and  returned 
sales,  and  use  Merchandise  as  a  clearing  account. 

May  I.  Johns  &  Peters  bought  merchandise  for  $7,000,  paying 
cash  for  $1,000  and  getting  into  debt  for  the  rest. 

May  2.  Johns  &  Peters  collect  $500  of  the  commission  money 
earned  by  them  in  the  preceding  period.    They  sell  goods  for  A.  An- 


156  THE  FUNDAMENTALS  OF  ACCOUNTING 

drews,  collecting  cash  $2,000,  of  which  $1,800  belongs  to  Andrews  and 
the  balance  they  are  entitled  to  keep  as  their  commission.  They  pay 
wages  $300. 

May  3.  They  sell  their  own  merchandise  as  follows:  $3,000  to  M. 
Mathews  on  account,  $4,000  for  cash  (to  M.  Marks),  and  $9,000  for  an 
interest-bearing  note,  dated  May  3,  of  the  Eureka  Company.  They 
return  $50  worth  of  the  cash  purchases  of  May  i  and  get  the  money. 

May  4.  They  pay  Andrews  $1,800,  and  sell  the  note  of  the  Eureka 
Company  for  $9,001.  Mathews  returns  $100  worth  of  the  goods  sold 
him  on  May  3.    They  collect  $3,000  on  accounts  receivable. 

Peters  dies  on  the  evening  of  May  4,  and  the  partnership  is  thereby 
dissolved,  and  the  books  must  be  brought  up  to  the  time.  Wages  are 
accrued  to  the  amount  of  $200  to  pay  and  rent  $215  to  pay;  the  fixtures 
are  worth  $2,000,  the  stock  of  merchandise  $14,000,  and  the  supplies 
$185.  All  other  items  are  as  shown  on  the  books.  Complete  the  en- 
tries necessary  to  indicate  all  facts  ready  for  the  division  of  profits 
between  the  surviving  partner  and  the  estate  of  the  deceased  partner, 
and  show  the  balance  sheet  as  of  the  close  of  business  May  4. 


CHAPTER  X 

THE  TRIAL  BALANCE 

The  Purpose.  We  have  seen  from  the  beginning  of  our  study 
that  assets  must  equal  ownership-claims,  and  that  debits  must 
equal  credits.  When  this  equality  is  not  attained,  something  is 
wrong.  In  making  entries,  great  care  is  taken  to  provide  for 
every  debit  an  exactly  equivalent  credit.  If  no  error  is  made  here 
and  no  subsequent  error  is  made  in  posting  and  in  finding  ledger 
totals,  obviously  the  sum  of  all  ledger  debits  must  equal  the  smn  of 
all  ledger  credits.  If  an  error  has  been  made  in  posting  a  wrong 
amount,  or  in  omitting  a  posting,  or  in  making  a  posting  twice, 
this  equality  will  not  be  preserved,  and  the  only  safe  thing  to  pro- 
tect one  against  such  errors,  and  they  are  easy  to  commit,  is  to 
make  a  test,  by  one  of  the  methods  discussed  later,  of  the  ledger 
and  see  that  debits  actually  equal  credits.  Such  a  test  is  called 
a  "trial  balance." 

The  Necessity.  Under  the  system  of  making  entries  described 
in  the  preceding  chapter,  hardly  anything  less  than  carelessness  on 
the  part  of  a  competent  bookkeeper  could  lead  to  an  error  that 
could  be  disclosed  by  the  trial  balance;  but  under  complicated 
systems  of  bookkeeping  using  labor-saving  devices,  as  described 
in  the  next  three  chapters,  entries  are  not  in  conveniently  ar- 
ranged halves,  between  which  any  discrepancy  is  apparent  ahnost 
at  a  glance,  but  are  split  between  many  different  books  and  pos- 
sibly many  different  columns  in  different  books,  and  error  may 
creep  unobserved  into  the  original  entries  as  well  as  into  the  post- 
ings. With  a  multiplication  of  the  opportunities  for  error,  the 
necessity  of  protection,  through  the  trial  balance,  against  errors 
that  might  otherwise  pass  imdetected  is  multiplied.  The  indica- 
tion of  error  given  by  the  trial  balance,  moreover,  is  nothing 
more  than  an  indication  of  error  —  that  is,  the  failure  of  the 
two  sides  of  a  trial  balance  to  show  equality  tells  nothing  more 
than  inequality  of  the  two  sides  and  existence  of  error:  it  gives 
no  information  about  the  size  of  the  error  or  about  the  number 
of  errors.  A  discrepancy,  between  the  two  sides,  of  one  cent  may 


158  THE  FUNDAMENTALS  OF  ACCOUNTING 

prove  to  be  due  to  a  dozen  errors  in  the  books,  for  five  errors  on 
the  debit  side  may  amount  to  omissions  of  five  thousand  dollars, 
and  seven  errors  on  the  credit  side  to  omissions  of  five  thousand 
dollars  and  one  cent,  and  yet  the  net  result  will  be  a  discrepancy 
of  one  cent  only.  The  trial  balance  tells  no  more  than  that  error 
is  there.  It  does  not  help,  except  by  giving  clues  to  those  who 
are  experienced,  in  finding  the  actual  errors.  Since  the  number 
of  errors  and  the  total  amount  of  error  is  not  disclosed  by  the 
trial  balance,  it  is  obviously  of  the  utmost  importance  that,  irre- 
spective of  the  amount  of  discrepancy,  when  the  trial  balance 
discloses  error  the  error  should  be  found.  To  neglect  the  dis- 
crepancy because  it  happens  to  be  small  is  to  walk  in  the  dark 
from  that  point  on. 

Limitations  of  the  Trial  Balance.  Yet  we  must  not  get  the 
impression  that  a  trial  balance  showing  equal  debits  and  credits 
indicates  that  the  books  are  right.  Not  only  may  many  errors  be 
made  without  disturbing  the  equality  of  the  two  sides  of  the  trial 
balance,  but  many  kinds  of  errors  may  be  so  made  —  if  they  hap- 
pen to  fall  just  right.  Yet  a  trial  balance  is  decidedly  worth 
while,  for  the  chances  are  slight  that  the  errors  will  fall  just  right 
to  escape  detection.  Only  one  error  is  h'kely  both  to  be  made 
and  to  escape  detection  through  the  trial  balance:  if  an  item  is  of 
the  correct  amount  and  on  the  correct  side  of  the  account  under 
which  it  stands,  but  chances  to  be  under  the  wrong  account,  the 
error  may  escape  notice  —  for,  as  it  enters  into  the  total  just  the 
same  whether  it  is  under  one  account  or  under  another,  the  only 
effect  on  the  trial  balance  is  its  appearance  (alone  or  in  combina- 
tion with  other  items)  under  a  wrong  title,  and  the  bookkeeper 
is  unlikely  to  know  or  to  remember  what  the  amount  of  any  ac- 
count ought  to  be.  So  a  trial  balance  that  is  satisfactory  in  ap- 
pearance tells  nothing  about  the  correctness  of  the  reported  con- 
dition of  the  individual  accounts  on  it;  it  merely  tells  that  unless 
an  error  has  been  made  in  carrying  an  item  to  a  wrong  account, 
the  probability  is  that  the  books  are  correct. 

Totals  or  Balances.  So  far  as  the  trial  balance  itself  is  con- 
cerned, it  is  equally  serviceable  whether  it  consists  of  a  list  of 
ledger  totals  or  of  ledger  balances.  The  theory  of  the  trial  bal- 
ance is  that  we  test  equality  of  debits  and  credits  on  the  ledger  as 


THE  TRIAL  BALANCE  1 59 

a  convenient  way  of  finding  probability  of  error,  and  therefore 
all  ledger  figures  are  involved.  In  reality,  however,  not  all  ledger 
figures  need  to  be  used,  for  many  of  them  have  already  once  been 
subject  to  that  test  and  may  be  eliminated  from  any  subsequent 
test.  An  account  which  has  been  closed,  which  now  has  no  bal- 
ance, must  have  in  itself  equality  of  debits  and  credits  (or  it  would 
have  a  balance),  and  hence  may  be  omitted  from  all  future  trial 
balances  (until  reopened,  of  course);  for  putting  it  on  the  trial 
balance  would  merely  add  the  same  amount  to  both  sides  of  the 
trial  balance  and  produce  no  effect  on  the  test  of  equahty.  Simi- 
larly, if  we  use  for  any  account  the  balance,  rather  than  the  total 
of  each  side,  we  are  serving  the  purpose  of  the  trial  balance  equally 
well,  for  the  omitted  portion  of  the  two  sides  must  be  the  same  (or 
else  the  balance  used  is  not  the  true  balance)  —  that  is,  if  an  ac- 
count has  debits  of  $300  and  credits  of  $200,  using  $100  on  the  debit 
side  only  is  as  good  as  using  the  total  of  each  side,  for  the  portion 
omitted  is  $200  from  each  side,  and  hence  the  omission  does  not 
affect  the  test  of  equality  of  debit  and  credit.  As  the  trial  balance 
is  often  kept  for  reference,  because  it  shows  the  recorded  status  of 
all  the  accounts  as  of  its  date,  it  may  in  some  cases  more  con- 
veniently show  balances  and  in  others  show  totals,  or  for  some 
accounts  it  may  show  balances  and  for  others  totals. 

Places  of  Error.  Let  us  now  examine  the  types  of  error  that 
are  likely  to  be  made  and  see  for  which  of"  them  the  trial  balance 
will  detect  that  an  error  has  been  made,  and  how.  It  should  be 
realized  at  the  start  that  an  error  may  be  made  in  any  or  all  of 
four  processes:  in  making  an  original  entry,  in  posting  an  original 
entry,  in  figuring  the  balance  or  the  total  of  the  ledger  account,  in 
drawing  up  the  trial  balance.  So  far  as  "getting  a  trial  balance" 
(that  is,  finding  equality  of  debit  and  credit  on  the  trial  balance) 
is  concerned,  an  error  in  one  of  these  processes  is  as  bad  as  in 
another,  and  the  trial  balance  will  detect  that  it  exists  as  well  if  it 
is  made  in  one  as  if  it  were  made  in  another.  These  errors  are  not 
equally  serious  in  themselves,  however,  for  some  of  them  have 
other  detectors  than  the  trial  balance,  and  therefore  might  not  go 
permanently  undiscovered  if  the  trial  balance  did  not  disclose 
them.  The  most  serious  errors,  of  course,  are  in  original  entries, 
for  these  will  stand  unless  challenged  from  outside  —  that  is,  they 


l6o  THE  FUNDAMENTALS  OF  ACCOUNTING 

have  no  internal  corrector  on  the  books  themselves.  Next  most 
serious  are  errors  in  posting,  for  they  will  stand  unless  challenged 
from  outside  or  by  comparison  with  the  original  entries  —  though 
they  have  a  corrector  in  the  original  entries  if  any  one  chances  to 
compare  them  with  the  original  entries.  Less  serious  are  errors 
in  j&guring  totals  or  balances  on  the  ledger,  for  evidence  of  their 
incorrectness  is  immediately  at  hand  in  the  figures  which  were 
added  or  subtracted,  and  they  are  also  subject  to  comparisons 
with  the  original  entries,  and  to  challenge  from  outside.  Least 
serious  are  errors  in  drawing  up  the  trial  balance  itself  (and  these 
errors  are  more  numerous  than  the  uninitiated  would  suspect), 
for  they  form  no  part  of  the  permanent  record  on  the  books,  and 
are  also  subject  to  the  three  detectors  already  mentioned  —  com- 
parison with  the  ledger  from  which  they  were  taken,  comparison 
with  original  entries,  and  challenge  from  outside. 

Addition  and  Subtraction.  Perhaps  the  commonest  error  is 
in  addition  or  subtraction.  If  an  original  entry  consists  of  several 
items  on  either  side  and  one  or  more  on  the  other  side  to  equal  a 
group  on  the  first  side,  and  then  an  error  is  made  in  adding  the 
items  of  the  group,  the  debits  will  not  equal  the  credits.  In  the 
simple  type  of  bookkeeping  so  far  discussed  this  ought  not  to 
occur,  for  with  the  debits  and  credits  contiguous  the  discrepancy 
should  be  observed  by  addition  of  the  two  columns  of  the  journal 
before  posting  is  made;  but  under  highly  developed  systems  the 
detailed  items  may  be  posted  from  several  books  on  many  occa- 
sions and  the  total  from  still  a  different  book.  If  an  error  is  made 
in  finding  the  total  or  balance  of  the  ledger,  too,  though  the  post- 
ings themselves  may  be  correct,  the  figure  used  in  the  trial  balance 
(taken  from  such  total  or  balance)  will  be  wrong  and  throw  out  the 
equality  of  debit  and  credit.  Finally,  if  all  the  figures  on  the  books 
are  correct  but  the  columns  of  the  trial  balance  are  improperly 
added,  the  equality  of  debit  and  credit  is  destroyed.  In  case  of 
error  in  addition  or  subtraction  the  trial  balance  should  disclose 
error  —  but  it  won't,  of  course,  show  what  the  error  is,  or  even 
of  what  type  it  is.  The  only  case  in  which  disclosure  of  error 
would  not  be  made  is  that  in  which  two  or  more  errors  exactly 
offset  each  other.  Obviously  the  offsetting  error  need  not  be  of 
the  same  type;  for  a  $50  omitted  posting  from  either  side  would 


THE  TRIAL  BALANCE  l6l 

cancel  an  error  of  addition  which  omitted  $50  from  the  other  side, 
and  a  double  posting  of  $50  on  either  side  would  cancel  an  omis- 
sion of  $50  by  erroneous  addition  on  the  same  side. 

Careless  Copying.  The  next  most  common  error  is  probably 
due  to  carelessness  (though  sometimes  it  is  due  rather  to  insensi- 
tive eye  or  ear  or  to  inaccurate  memory  than  to  true  carelessness). 
A  figure  is  read  wrongly,  or  heard  wrongly,  or  remembered  wrongly, 
or  written  wrongly.  It  is  easy  to  write  $1.10  for  $110,  $1.53  for 
$1.35,  $2.68  for  $20.68.  If  the  error  is  made  in  the  original  entry 
on  both  sides,  the  trial  balance  will  not  disclose  it,  for  debits  and 
credits  will  still  be  equal;  but  if  it  is  made  on  one  side  only,  or  in 
posting  one  side  only,  or  in  entering  ledger  balances,  or  in  entering 
items  on  the  trial  balance,  the  trial  balance  should  show  that 
error  has  been  made  —  unless,  of  course,  the  error  is  offset  by 
another  error. 

Omissions  and  Duplications.  It  is  not  common  inadvertently 
to  omit  or  to  duplicate  part  of  an  original  entry,  even  when 
parts  are  scattered,  if  one  has  a  systematic  method  of  entry; 
but  a  Httle  carelessness  in  posting  may  easily  lead  either  to  omis- 
sion or  to  duplication  on  the  ledger,  for  posting  is  a  mechanical 
process  involving  little  consciousness  of  the  significance  of  what 
is  posted;  and  hence  posting  checks  should  always  be  made  as  soon 
as  a  posting  is  made  and  never  before.  A  conmion  error  is  failing 
to  observe  some  item  in  figuring  ledger  balances  —  as  when  an 
account  has,  say,  twenty  debits  and  only  one  credit,  and  the  credit 
is  overlooked  in  finding  the  figure  for  the  trial  balance.  Almost 
equally  common  is  failing  to  observe  some  account  in  drawing  off 
the  trial  balance  from  the  ledger.  Any  one  of  these  errors  (of 
original  entry,  on  the  ledger,  in  finding  ledger  totals  and  balances, 
and  in  drawing  off  the  trial  balance)  will  cause  the  trial  balance 
to  show  that  error  has  been  made  —  unless  it  is  offset  by  another 
error  or  errors. 

Confusing  Debits  and  Credits.  If  an  item  is  debited  to  an  ac- 
count when  it  should  be  credited,  the  equality  of  debits  and  cred- 
its is  thrown  out,  unless  the  other  half  of  the  entry  is  also  re- 
versed— in  which  case  the  trial  balance  cannot  disclose  error,  for 
equality  is  preserved.  This  will  be  true  whether  the  error  is  in 
the  original  entry,  in  posting,  or  in  drawing  off  the  trial  balance. 


1 62  THE  FUNDAMENTALS  OF  ACCOUNTING 

Confusing  Accounts.  If  an  item  is  carried  to  a  wrong  account 
in  an  original  entry,  the  chances  of  detection  are  few  except  from 
causes  outside  tj;ie  books  —  as  some  one's  observing  that  the  record 
does  not  agree  with  the  facts,  —  for  the  trial-balance  equality  of 
debit  and  credit  is  not  affected,  and  there  are  no  previous  book 
records.  Virtually  the  same  thing  is  true  of  a  confusion  between 
accounts  in  posting:  here  a  chance  (or  intentional)  comparison 
with  the  original  entry  would  show  the  error,  though  the  trial 
balance  would  not.  A  confusion  between  accounts  on  the  trial 
balance  itself  (attaching  the  wrong  name  to  an  amount)  would 
do  no  harm  so  far  as  the  trial  balance  itself  is  concerned,  for  equal- 
ity of  debits  and  credits  is  not  affected;  but  if  the  trial  balance  were 
used  for  reference,  to  show  how  certain  accounts  stood  at  a  cer- 
tain time,  it  might  do  much  harm.  Hence,  all  things  considered, 
the  greatest  care  must  be  taken  to  see  that  entries  do  not  get  made 
to  wrong  accounts,  for  detection  is  improbable  through  ordinary 
routine  bookkeeping  procedure. 

Finding  Errors.  As  already  indicated,  the  trial  balance  gives 
indication  of  most  errors,  but  gives  no  indication  of  the  number 
of  errors,  the  kind  of  errors,  the  amount  of  the  errors,  or  the 
accounts  which  are  wrong.  To  find  errors  is  often  the  most  diffi- 
cult task  of  a  bookkeeper.  Of  course  the  obvious  thing  is  to  go 
over  all  the  work  again,  though  perhaps  reversing  the  order  of 
procedure  —  adding  the  trial  balance,  comparing  the  trial  balance 
with  the  ledger  totals  or  balances,  refiguring  ledger  totals  or  bal- 
ances, checking  all  the  postings,  examining  all  the  original  en- 
tries. This,  however,  is  not  the  usual  procedure;  for  certain  er- 
rors are  more  probable  than  others  and  might  be  looked  for  with 
less  work  than  others,  so  that  less  work  is  wasted  if  the  error  is 
not  of  that  sort.  The  order  of  procedure  will  therefore  depend  on 
circumstances,  and  need  not  be  discussed  in  detail  here.  A  few 
general  cues  for  looking  for  error  are  suggestive,  however.  Some- 
times mere  inspection  of  the  trial  balance  will  show  that  some  ac- 
count has  been  placed  as  a  credit  when  it  clearly  must  be  a  debit, 
or  that  the  amount  is  impossibly  large  or  small.  If  the  difference 
between  the  debits  and  the  credits  of  the  trial  balance  is  one  digit 
only,  as  Dr.  $156,814.23  and  Cr.  $158,814.23,  there  is  a  probability 
that  the  error  is  due  to  carelessness  somewhere  in  addition  or  sub- 


THE  TRIAL  BALANCE  163 

traction.  If  it  is  divisible  by  two,  it  may  be  due  to  carrying  some 
item  to  the  wrong  side  (for  that  makes  one  side  too  small  and  also 
the  other  too  large  by  the  same  amount,  and  so  doubles  the  dis- 
crepancy) —  though  it  must  be  remembered  that  half  of  all  con- 
ceivable numbers  are  divisible  by  two.  If  the  discrepancy  is 
divisible  by  nine,  there  is  a  probability  that  the  error  is  due  to  care- 
less use  of  the  decimal  point,  as  with  $1.10  for  $110,  or  transposi- 
tion of  figures,  as  with  $1.53  for  $1.35,  or  omitting  or  inserting 
ciphers,  as  with  $2.68  for  $20.68,  or  vice  versa.  Yet  however  many 
hints  one  gets  of  where  the  error  may  be,  all  may  be  deceptive  and 
a  long  search  may  disclose  an  unusual  sort  of  error.  Sometimes 
discrepancy  persists  even  after  checking  over  all  the  work  care- 
fully and  making  sure  that  no  errors  have  been  made.  The  nat- 
ural conclusion  is  that  this  month's  entries  and  postings  (as- 
suming that  a  trial  balance  is  taken  monthly)  are  correct  but  that 
two  errors  made  last  month  offset  each  other  and  hence  were  not 
detected,  and  that  on  this  month's  trial  balance  one  of  them  was 
not  repeated  and  consequently  the  other  was  left  unmated  and 
disclosed.  Then  the  error  in  last  month's  books  must  be  found. 
An  error  on  the  books  offset  by  an  error  on  the  trial  balance  is 
thus  less  serious  than  one  offset  by  another  error  on  the  books;  for 
the  former  will  be  found  sooner  or  later  when  a  trial  balance  on 
which  the  offsetting  error  is  not  made  will  show  that  something  is 
wrong,  whereas  the  latter  may  never  be  discovered. 

QUESTIONS  AND  PROBLEMS 

I.  Assuming  that  each  balance  on  the  following  trial  balance  is  entered 
to  the  right  account,  find  the  actual  and  the  probable  errors,  and  show 
the  presumably  correct  trial  balance. 

Cash  14,930 

Partner  A  (Investment)  9,975 

Partner  B  (Investment)  10,000 

Interest  8 

Equipment  430 

Advertising  90 

Commission  457 

Merchandise  1,122 

Real  Estate  ii,Soo 

Accounts  Receivable  1,150 

Accounts  Payable  6,520 

28,085        28,097 


164  THE  FUNDAMENTALS  OF  ACCOUNTING 

2.  If  you  were  the  manager  of  a  business  and  wished  to  see  the  trial  balance 
in  order  to  determine  your  business  policy,  should  you  wish  the  trial 
balance  to  be  made  up  all  of  ledger  totals,  all  of  ledger  balances,  or  in 
part  of  ledger  totals  and  in  part  of  ledger  balances?  Should  you  wish 
entered  on  the  trial  balance  totals  of  accounts  which  at  the  time  of 
taking  the  trial  balance  have  no  balances?    Why  or  why  not? 

3.  You  find  a  discrepancy  in  your  trial  balance.  You  then  again  add 
all  postings  of  the  current  month  to  the  ledger  totals  at  the  end  of  the 
previous  month  and  find  that  the  new  totals  are  in  agreement  with 
your  trial-balance  figures.  Next  you  check  all  postings  with  the  orig- 
inal entries  for  the  month,  but  find  no  error.  Lastly  you  examine 
the  original  entries  for  the  month,  and  find  them  to  be  correct. 
Should  you  abandon  your  himt  for  the  discrepancy?  If  not,  what 
should  you  do?  If  you  should  abandon  the  search  for  the  discrepancy 
how  should  you  put  the  books  again  in  balance? 


CHAPTER  XI 

THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES  IN  BOOKS 
OF  ORIGINAL  ENTRY 

The  Special  Column.  A  glance  at  the  journal  given  in  Chapter 
IX,  page  150,  shows  that  many  postings  have  to  be  made  to  the 
credit  of  Cash.  This  suggests  that  any  device  for  segregating 
the  credits  to  Cash,  so  that  one  posting  of  the  total  might  serve, 
would  be  worth  while ;  for,  since  the  ledger  is  not  intended  to  show 
details,  one  posting  of  totals  will  do  as  well  as  a  separate  posting  for 
each  payment.  An  obvious  device  for  this  purpose  is  a  special,  or 
second,  credit  column,  in  the  journal,  in  which  all  amounts  to  be 
credited  to  Cash  may  be  entered  and  be  thus  temporarily  segre- 
gated. The  total  of  this  column  will  then  be  taken  whenever 
postings  are  to  be  completed,  and  the  amount  of  the  total  will  be 
posted  to  the  credit  of  Cash.  At  the  same  time  this  total  will  be 
extended  into  the  other  credit  column  in  the  journal,  from  which 
the  items  extended  into  the  cash  coliman  have  been  omitted,  in 
order  that  we  may  prove  our  work  by  seeing  that  our  total  debits 
equal  our  total  credits.  Instead  of  the  journal  page  shown  on  page 
150,  then,  we  shall  have  a  page  of  three  columns;  and  at  the  end 
of  each  page  the  totals  must  be  carried  over,  so  as  to  get  the  totals 
for  cash  and  for  proof.    This  gives  us  the  following  final  figures : 

Cash,  Cr. 


26,690 


7,700 


26,690 


00 


00 


7,700 


00 


One  posting  as  a  credit  to  Cash  takes  the  place  of  six,  and  would 
equally  weU  take  the  place  of  five  hundred  if  there  were  so  many 
items  during  the  period  at  the  end  of  which  it  is  desirable  to 
have  the  ledger  brought  up  to  the  times.  As  a  protection  against 
misunderstanding,  however,  it  would  be  undesirable  to  have  the 
posting  check,  or  ledger  folio,  appear  opposite  each  item  of  cash 
as  well  as  opposite  the  total;  the  journal  should  show  on  its  face 
that  not  the  individual  items  but  the  total  only  has  been  posted. 
Leaving  the  space  blank,  however,  is  confusing;  for  the  book- 
keeper is  going  to  be  bothered  by  the  constant  suggestion,  through 
the  blank  spaces,  that  some  postings  have  been  missed:  posting 
is  not  usually  done  consecutively,  item  by  item,  for  it  is  a  saving 


i66 


THE  FUNDAMENTALS  OF  ACCOUNTING 


of  labor  to  skip  about  on  the  journal  in  posting  and,  while  one  has 
page  3,  for  instance,  of  the  ledger  open,  to  post  all  items  belonging 
on  page  3,  and  then  check  them  in  the  journal  as  posted.  The 
confusion  of  skipped  spaces  is  avoided  by  using  a  blank  check  (y/) 
to  indicate  that  though  posting  of  this  individual  item  is  not  made, 
its  posting  is  provided  for  elsewhere — as  here  by  the  posting  of  the 
total  of  the  column.  Then  the  eye  of  the  bookkeeper  is  able  to  see 
at  a  glance  whether  all  items  to  be  posted  have  been  provided  for. 
Wide  Applicability.  In  the  transactions  of  Chapter  IX,  which 
we  have  just  used  for  illustration,  the  disbursement  of  cash  hap- 
pens to  be  the  only  kind  of  transaction  occurring  often  enough  to 
make  a  special  column  worth  while.  In  reality,  however,  the  ex- 
penses and  sales  would  usually  each  comprise  many  items  instead 
of  one,  and  therefore  each  could  well  be  given  a  special  column. 
To  see  further  use  of  the  special  column,  let  us  suppose  that  we 
have  a  large  number  of  transactions  within  a  short  period,  of 
which  many  are  of  a  kind,  like  expenses  paid  in  cash,  purchases 
for  cash,  sales  on  account,  and  collections  of  accounts.  Simpli- 
fying the  entries  by  omitting  the  detailed  or  explanation  portions 
and  showing  the  journalization  only,  we  may  get  the  following: 


Cash 
Dr. 

Accts. 
Rec. 
Dr. 

Pur- 
chases 
Dr. 

Ex- 
penses 
Dr. 

V 
V 

April  29 

Purchases 

To  Cash 

Sundnes 
Cr. 

Sales 
Cr. 

Accts. 
Rec. 
Cr. 

Cash 
Cr, 

1,000 

00 

1,000 

00 

Soo 

00 

V 

Expenses 
i-oCash 

SOO 

00 

3.000 

00 

>/ 
v 

Accounts  Rec. 
To  Sales 

3.000 

00 

8 

00 
00 

IS 

Cash 
To  Com'n. 

Cash 
To  Accounts 
Rec. 

8 

00 

S.3SO 

00 

SO 

00 

16 

Cash 
To  Interest 

50 

00 

00 

00 

3,000 

00 
00 

00 
00 
00 
00 

00 

\f 

Is 

21 

25 

9 

32 
25 
9 

Purchases 
To  Cash 

Expenses,  Dr. 
Purchases,  Dr. 
Accts.Rec.Dr. 
Cash,  Dr. 
Sales.  Cr. 
Accts.  Rec.,  Cr. 
Cash.  Cr. 

3,000 
S.350 

4.500 

00 
00 
00 
00 

00 

00 

3.000 

00 

Soo 
4,000 
3.000 
5. 408 

4.000 

5,408 

3.OC0 

3,000 

S,3SO 

4.S00 

00 

12,908 

12,908 

THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES        167 

It  will  be  observed,  first,  that  however  many  entries  there  might 
be,  even  several  hundred,  no  more  postings  would  be  required  if 
all  the  additional  items  were  to  be  entered  in  the  special  columns 
already  provided;  for  though  the  totals  would  be  increased  in 
size,  no  more  totals  would  need  posting.  It  will  be  observed, 
secondly,  that  one  column  is  not  posted  in  total,  for  it  is  not  a 
special  column;  i.e.,  it  is  marked  "sundries,"  and  is  to  take  mis- 
cellaneous items  too  infrequent  to  be  worth  the  trouble  (or  space) 
of  providing  with  special  columns.  Items  in  that  column  cannot 
be  posted  in  total,  for  they  are  dissimilar,  to  be  posted  to  different 
accounts,  and  hence  must  be  posted  individually  as  in  our  original 
journal  shown  on  page  150.  Normally  when  this  book,  called  a 
**special-colimin  journal,"  is  used,  a  sundries  colimin  would  be 
provided  on  the  debit  side  also;  but  our  transactions  in  this  case 
did  not  require  it.  The  placing  of  the  journalization  (and  ex- 
planations of  detail)  in  the  middle  of  the  page  is  purely  for  con- 
venience. The  form  has  utmost  flexibility.  If  so  many  columns 
are  used  that  too  much  space  is  taken  at  the  end  in  simimarizing 
them,  as  shown  above,  all  the  totals  may  be  taken  on  the  same 
line;  and  the  posting  from  each  may  be  made  directly  without 
label,  with  the  ledger  folio  for  posting  check  written  beneath  each 
total  (usually  enclosed  in  a  circle  or  oval  to  distinguish  it  from 
financial  figures).  The  total  of  all  columns  of  each  side  should  be 
taken  and  shown  somewhere,  however,  to  give  assurance  (by 
proof)  that  the  debits  equal  the  credits. 

Extension  of  the  Principle.  The  form  just  shown  may  easily 
become  very  cumbersome  if  so  many  accounts  have  frequent 
items  that  many  special  columns  are  worth  while.  It  is  notable 
that  most  transactions  fall  within  certain  well  defined  groups,  and 
certain  combinations  of  debits  and  credits  virtually  never  occur. 
Expense  accoimts  are  virtually  never  directly  connected  in  the 
same  transaction  with  purchases  and  sales,  for  instance.  When 
our  columnar  journal  is  in  danger  of  becoming  too  cumbersome, 
therefore,  we  may  split  it  and  put  in  separate  volumes  certain 
columns  that  commonly  are  used  together.  It  is  common,  for  ex- 
ample, to  put  into  separate  books  all  cash  transactions  (into  what 
is  called  the  "cash  journal"  or  "cash  book"),  all  purchase  items 
(into  what  is  called  the  "purchase  journal"  or  "invoice  book"), 


i68 


THE  FUNDAMENTALS  OF  ACCOUNTING 


and  all  sales  (into  what  is  called  the  "sales  journar^  or  *' sales 
book").  Then  in  each  may  be  put  such  special  columns  as  are 
likely  to  be  useful,  and  in  each  may  be  a  sundries  column  that 
will  take  care  of  items  which  must  be  posted  individually  because 
they  are  too  infrequent  to  have  special  columns  for  posting  in 
total. 

The  Cash  Book.  The  cash  book  should  have  in  it  all  cash 
items,  for,  though  of  course  cash  items  may  perfectly  well  be 
posted  from  other  sources,  it  is  desirable  to  know  that  all  cash 
items  are  in  one  place  not  only  in  summary  (as  in  the  ledger)  but 
in  detail  for  inspection  and  reference,  and  ready  for  finding  in- 
stantly the  cash  balance.  In  order  to  keep  the  debit  and  credit 
sides  in  juxtaposition,  for  ease  in  finding  the  balance  at  any  time, 
entries  involving  debits  to  cash  are  usually  written  on  the  left 
side  (as  the  book  Ues  open)  of  the  cash  book,  and  credit  entries  on 
the  right;  and  whenever  the  balance  is  entered,  in  fashion  similar 
to  that  of  balancing  a  ledger  account  as  shown  on  page  145,  a 
fresh  start  is  made  on  the  two  pages  side  by  side  on  corresponding 
lines.  It  will  be  noted  that  by  the  very  theory  of  the  book  all 
items  in  this  book  are  cash  items.  Hence  it  is  imnecessary  to  pro- 
vide in  it  any  columns  for  Cash,  for  the  left  side  of  the  book  is 
itself  a  whole  page  of  Cash  debits,  and  the  right  side  is  a  whole 
page  of  Cash  credits.  We  have  therefore  eliminated  not  only  two 
colimins,  but  the  writing  of  all  items  that  would  go  into  such  col- 
lunns  if  cash  items  were  entered  in  the  columnar  journal  as  previ- 
ously shown.  Let  us  observe  an  illustration,  using  the  same 
items  as  on  page  166. 


April  30 

16 

25 

15 

9 

May    I 

V^ 

Commission 

Accounts  Receivable 

Interest 

Accounts  Receivable 

Commission 

Cash,  Dr. 

Balance 


Cash  Receipts 


on  sales  for  J.  G.  &  Co. 
H.  K.  P.ipaidlnv.  3/19 
on  bank  balances 
total  for  month 


Accts. 

Com- 

Rec'ble 

mtsston 

8 

00 

S.3SO 

00 

5.3SO 

00 



8 

00 

Sun- 
dries 


so 
SvSSo 


S,4o8 


908 


*  ^  It  is  usually  desirable  to  handle  such  items  individually  as  well  as  in  total,  and  this  will  be  discussed 
in  the  next  chapter. 


THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES        169 


April  39 
April  30 


Purchases 
Expenses 
Purchases 
Purchases 
Expenses 
Cash,  Cr. 
Balance 


Cash  Disbursements 


Invoice  j^88 
Sundry  items,  Vo.  #24 
Invoice  #118 
total  for  month 


Pur- 
chasts 

Ex- 
penses 

Sun- 
dries 

1,000 
3.000 

00 

00 
00 

Soo 
"soo 

00 
00 

4,000 
500 

4.000 

00 
00 

4.500 
908 

00 
00 

S.408 

00 

It  will  be  observed  that  here  the  totals  of  special  columns  are  car- 
ried at  the  end  of  the  period  into  the  sundries  column  so  that 
cash  totals  may  be  shown.  The  journalization,  in  the  first  text 
column,  is  incomplete,  for  the  fact  that  Cash  is  to  be  debited  or 
credited  is  apparent  from  the  presence  of  the  item  in  this  book, 
and  the  page  (left  or  right)  indicates  whether  a  debit  or  a  credit 
is  to  be  given.  The  explanation  portion  of  the  entry,  written  on 
the  same  line  in  the  next  column,  is  directly  attached  to  the 
journalization  and  hence  is  very  conveniently  placed.  At  the 
foot  of  each  page  the  posting  to  be  made  to  Cash  is  specially 
labeled,  for  it  is  the  complement  of  all  other  postings  from  that 
page,  and  to  make  easy  work  for  the  bookkeeper  or  posting  clerk 
a  reminder  should  catch  his  eye  that  at  this  point  he  is  to  stop 
posting  credits  and  post  a  debit,  or  vice  versa. 

Cash-Book  Balances.  Each  month's  record  of  cash  must  begin 
with  the  cash  on  hand  left  over  from  the  preceding  month;  but 
this  clearly  must  not  be  debited  to  Cash  at  the  end  of  the  new 
month,  for  it  has  already  been  debited  in  the  month  in  which  it 
was  received.  In  finding  the  total  to  be  posted  as  a  debit  to  Cash 
at  the  end  of  the  month,  therefore,  the  balance  brought  over  at 
the  beginning  must  be  omitted.  A  convenient  device  is  a  special 
column  for  the  balance,  which  then  may  be  added  to  the  receipts 
after  the  total  has  been  found.  Another  convenient  device  is  to 
subtract  the  old  balance  in  short-extension  from  the  total  which 
includes  it,  and  indicate  that  the  amount  to  be  posted  is  the  dif- 
ference. In  the  form  shown  above,  for  instance,  the  new  balance 
for  May  i  is  $908.  If  the  receipts  for  May  should  be  $7,000, 
the  total  of  the  sundries  column,  after  special-column  totals  were 
carried  to  it,  would  be  $7,908,  but  only  $7,000  should  be  posted 


I70  THE  FUNDAMENTALS  OF  ACCOUNTING 

as  a  debit  to  Cash.  To  indicate  this,  the  last  line  for  May  might 
read  as  follows: 

I  9  I  Cash,  Dr.   |  Jjlial..!:^  7,000.00  to  post  ||  |    ||  |    ||  7,9o8|oo 

This  inconvenience  of  arrangement  is  avoided  when  the  cash  book 
is  used  itself  as  a  ledger  account,  as  many  bookkeepers  use  it,  and 
no  cash  is  kept  in  the  ledger.  Since  the  purpose  of  the  ledger  is  to 
classify  items  so  that  we  may  get  totals  and  balances,  and  since 
the  cash  book  has  already  got  totals  and  balances,  nothing  more 
is  necessary  for  cash  record.  The  only  advantage  of  having  a 
ledger  account  for  cash  is  that  then  the  ledger  is  complete  and  the 
item  of  cash  is  less  likely  to  be  forgotten  in  drawing  up  a  balance 
sheet  or  trial  balance;  and  the  labor  of  posting  cash  monthly  (it 
is  seldom  posted  oftener)  is  neghgible.  Whether  one  shall  carry 
a  ledger  accoimt  for  cash  in  addition  to  a  cash  book  is,  then,  a  mat- 
ter of  taste  and  not  of  principle. 

Cash-Book  Ruling.  It  is,  as  we  have  seen,  desirable  to  have 
both  sides  ruled  up  on  corresponding  lines,  for  since  usually  the 
number  of  receipt  items  does  not  closely  follow  the  number  of  dis- 
bursement items  the  current  position  for  one  side  is  constantly 
nmning  ahead  of  the  position  for  the  other  side,  and  it  is  incon- 
venient in  finding  balances  to  have  the  positions  far  apart.  This 
means  that  on  one  side  or  the  other  when  the  balance  is  entered 
and  the  totals,  for  equality,  are  shown,  blank  lines  are  left  on  the 
side  with  the  fewer  items.  These  have  sometimes  proved  tempt- 
ing to  dishonest  bookkeepers  or  cashiers,  who  have  inserted  fic- 
titious entries  and  thereby  hidden  tampering  with  cash.  Many 
bookkeepers  rule  diagonal  red  lines  across  such  blank  spaces  to 
cancel  them.  Such  lines,  when  they  run  at  various  angles  as  they 
usually  do,  are  unsightly.  A  substitute  is  to  take  the  total  of 
each  side  of  the  cash  book  on  the  first  line  available,  regardless  of 
the  relative  position  of  the  two  sides,  thus  closing  each  side  from 
new  entries,  and  then  on  the  side  with  the  blank  space  repeat  the 
total  on  the  line  opposite  the  total  of  the  other  side.  Then  no  in- 
sertions can  be  made  without  advertising  the  fact  that  they  were 
made  after  the  total  was  taken. 

The  Purchase  Book.  It  is  customary  similarly  to  keep  a  sep- 
arate book  for  purchases  of  merchandise,  for  such  transactions 


THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES        17I 


involve  an  almost  constant  set  of  relations  that  are  not  usually  in- 
volved in  other  transactions  —  chiefly  debits  to  Purchases  and 
credits  to  Accounts  Payable.  Indeed,  the  purchase  book  as  a 
whole  is  virtually  one  entry,  equivalent  to  a  single  journal  entry: 

Purchases 
To  Accounts  Payable 

So  far  as  purchases  are  of  this  normal  type,  obviously  the  purchase 
book  can  consist  merely  of  a  list  of  purchases,  summarized  at 
the  end  of  the  period  into  a  single  entry  as  indicated  above,  and 
that  entry  can  be  posted  from  the  purchase  book  or  entered  in  the 
journal  and  posted  thence,  as  one  may  prefer.  As  a  matter  of 
fact,  however,  sometimes  other  kinds  of  purchases  are  made,  as 
for  cash  or  for  notes  payable,  and  therefore  the  purchase  book 
must  provide  for  credits  to  other  accounts  than  Accoimts  Payable. 
This  is  most  conveniently  accompHshed  by  providing  for  two 
columns,  one  for  Accounts  Payable,  the  total  to  be  posted  to  the 
credit  of  that  account,  and  the  other  for  sundries,  which  will  be 
individually  posted.  The  sum  of  the  two  columns  will  then  be 
posted  to  the  debit  of  Purchases.  The  method  of  handling  the 
postings  is  indicated  by  the  form  below,  which  illustrates  only  a 
few  typical  items. 


Apr.  29 


Accounts  Payable 
Accounts  Payable 
Notes  Payable 
Accounts  Payable 
Purchases,  Dr. 


J.  Smith  1  Invoice  #6841 
J.Jonesi 


#6842 
#6843 


total 


Auls 

Payab 

'e 

Sun- 
dries 

S18 
619 

50 
80 

30 

1,087 
1.138 

SO 

1.138 

30 

2,225 

80 

*  The  handling  of  the  items  of  J.  Smith  and  T.  Jones  individually  will  be  discussed  in  the  next  chapter 
r  we  are  here  concerned  with  Accounts  Payaole  as  a  whole  and  not  with  the  individual  details  of  whicl 


for  we  are  here  concerned  with  Accounts  Payable  as  a  whole  and  not  with  the  mdividual  details  of  which 
our  debts  are  made  up. 

If  the  business  is  divided  into  departments,  a  special  column  (and 
separate  account)  is  provided  for  the  purchases  of  each  depart- 
ment, increasing  the  number  of  debits  but  not  affecting  the  credits. 
The  Sales  Book.  Absolutely  the  same  principle  applies  to 
Sales.  They  are  involved  in  but  few  kinds  of  transactions,  and  the 
items  involved  are  not  usually  involved  in  other  transactions:  so 
sales  may  well  be  handled  in  a  separate  book,  really  a  subdivision 
of  the  journal,  sometimes  called  the  Sales  Journal.  The  handling 
is  identical  with  that  of  the  purchase  book  —  except,  of  course, 
that  things  are  reversed,  i.e.,  Accounts  Receivable  is  debited  and 


172  THE  FUNDAMENTALS  OF  ACCOUNTING 

Sales  is  credited,  whereas  in  the  purchase  book  Accounts  Payable 
is  credited  and  Purchases  is  debited.  Department  sales  may  be 
credited  separately,  of  course,  for  each  department. 

Division  of  Entries.  Now  that  we  have  our  original  journal 
cut  up  into  several  journals,  a  policy  with  regard  to  the  disposition 
of  entries  becomes  necessary,  or  one  may  not  know  where  to  look 
to  find  a  particular  entry.  Since  we  desire  all  cash  items  to  be  in 
the  cash  book  so  that  we  can  test  cash  balances  easily,  our  policy 
with  regard  to  that  book  is  clear.  Since,  too,  the  maximum  labor 
saving  is  accomplished  by  putting  entries  in  special  books,  like 
the  cash  book,  the  purchase  book,  and  the  sales  book,  because  in 
them  one  side  of  the  entry  is  automatically  recorded  merely  by  the 
fact  that  the  entry  is  placed  in  a  certain  book,  it  is  desirable  al- 
ways to  use  the  special  journals  rather  than  the  general  journal 
whenever  there  is  no  special  reason  for  the  other  course.  Occa- 
sionally there  is  reason  for  splitting  an  item  between  books.  Sup- 
pose a  partner  is  taken  into  a  business,  and  he  contributes  as  his 
investment  $5,000  in  cash,  a  stock  of  merchandise  worth  $15,000, 
and  real  estate  worth  $25,000.  Normally  the  cash  would  be  en- 
tered in  the  cash  book,  the  merchandise  in  the  purchase  book,  and 
the  real  estate  in  the  journal;  and  this  would  serve  all  purposes 
but  one:  it  would  not  give  us  in  one  place  a  complete  story  of  the 
partner's  investment.  We  can,  by  using  proper  care,  provide 
such  a  complete  story  in  the  journal  and  still  have  the  special 
parts  of  the  transaction  appear  in  the  various  special  journals,  and 
all  without  duplicate  postings.  We  saw  in  connection  with  our 
first  study  of  special  columns  that  a  blank  posting  check  may  be 
used  to  indicate  that  posting  is  not  made  from  the  entry  to  which 
it  is  attached  but  is  elsewhere  provided  for.  We  may  use  that 
device  here  to  head  off  double  postings:  i.e.,  we  may  enter  the 
transaction  as  many  times  as  convenient  and  head  off  the  posting 
of  duplicate  items  by  inserting  the  blank  posting  check  at  the 
time  any  duplicate  entry  is  made.  In  this  case,  we  wish  to  pro- 
duce  the  effect  of  the  following  entry: 


45,000 


Cash 

5,000 

Purchases 

15,000 

Real  Estate 

25,000 

To  J.  Brown 

THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES        173 

We  can  make  this  entry  in  full  in  the  journal,  with  complete  ex- 
planation. Since,  however,  we  wish  cash  also  on  the  cash  book, 
and  it  will  be  awkward  to  exclude  it  from  the  total  debits  to  Cash 
at  the  end  of  the  month,  we  should  see  that  the  $5,000  is  not  posted 
to  Cash  from  the  journal  entry  above  —  and  so  we  put  a  blank 
check  in  the  posting-check  column  as  soon  as  we  make  the  entry 
in  the  cash  book.  Since,  moreover,  we  intend  to  post  the  total 
credit  to  J.  Brown  from  the  journal,  we  must  not  post  the  credit 
to  Brown  also  from  the  cash  book,  and  so  we  check  the  item  in  the 
posting-check  column  in  that  book.  We  proceed  in  the  same  way 
with  the  merchandise.  We  enter  it  in  the  purchase  book,  check 
the  item  there  so  that  though  it  will  be  posted  as  a  debit  (in  the 
total)  to  Purchases,  it  will  not  be  posted  as  a  credit  to  Brown,  and 
then  we  check  it  in  the  journal  so  that  it  will  not  be  thence  posted 
to  Purchases.  The  Real  Estate  is  posted,  of  course,  from  the 
journal,  for  it  is  nowhere  else.  To  sunamarize  this:  we  use  blank 
check  marks  to  head  off  duplicate  postings  from  the  inconvenient 
places,  and  then  the  Cash,  Dr.  is  posted  from  the  cash-book  total, 
the  Purchases,  Dr.  from  the  purchase-book  total,  the  Real  Es- 
tate, Dr.  and  the  Brown,  Cr.  from  the  journal,  and  no  duplicate 
credit  is  posted  to  Brown  from  either  the  cash  book  or  the  pur- 
chase book.  The  same  device  can  be  used  when  cash  sales  or 
purchases  are  made  and  it  is  desired  to  show  the  cash  on  the  cash 
book  and  the  sale  or  the  purchase  on  the  sales  book  or  the  pur- 
chase book.  Blank  checking  heads  off  a  duplicate  posting  to 
Sales  or  Purchases  from  the  cash  book,  and  a  duplicate  posting  to 
Cash  from  either  of  the  other  books. 

Division  of  Transactions.  Sometimes  it  is  desirable  to  treat 
what  is  in  essence  one  transaction  as  if  it  were  two  or  more.  If  a 
customer  makes  part  payment  on  a  purchase  and  has  the  rest 
charged  to  his  account,  it  is  unfortunate  to  treat  the  sale  as  partly 
a  cash  and  partly  a  charge  transaction;  it  should  usually  be 
treated  as  two  separate  transactions,  a  charge  sale  for  the  full 
amount  of  the  bill,  and  a  partial  cash  payment  on  a  debt.  The 
customer's  ledger  account  (kept  in  a  subordinate  ledger  to  be 
described  in  the  next  chapter)  must  show  the  amount  of  the  debt. 
If  the  sale  is  treated  as  only  partly  a  charge  sale,  only  the  amoimt 
not  paid  in  cash  will  be  carried  to  his  ledger  accoimt.    In  any  case 


174  THE  FUNDAMENTALS  OF  ACCOUNTING 

of  future  reference  to  this  item  one  would  naturally  be  looking  to 
identify  it  by  the  amount  of  the  bill,  unless  one  chanced  to  re- 
member that  part  payment  was  made  in  cash;  but  the  amount  of 
the  bill  would  not  be  the  amount  of  the  charge.  Simply  as  a  mat- 
ter of  convenience,  therefore,  it  is  best  to  let  the  ledger  show  the 
natural  unit,  or  the  full  bill,  as  a  charge,  and  the  payment  as  a 
payment  on  the  charge  rather  than  as  a  payment  on  a  cash  pur- 
chase. Similarly  if  we  customarily  have  purchases  charged  but 
occasionally  give  a  note  payable  at  the  time  of  purchase,  it  is  wise 
to  enter  the  transaction  as  two  —  a  charge  purchase,  and  the  giv- 
ing of  a  note  in  settlement  of  the  charge  —  rather  than  as  a  simple 
purchase  for  a  note.  This  assures  us  that  the  transaction  will  get 
carried  through  the  subordinate  ledger  for  our  creditor,  be  en- 
tered under  his  name,  and  hence  be  traceable  in  future.  Indeed, 
whenever  it  will  be  advantageous  to  have  an  item  indexed  under 
the  name  of  a  customer  or  a  creditor,  it  is  well  to  run  it  wholly 
through  his  account,  both  debited  and  credited,  even  though  cash 
is  paid,  rather  than  short-cut  it  around  his  account  as  a  cash  item. 
Abuse  of  Labor-Saving.  The  modern  passion  for  short-cuts 
must  not  be  carried  so  far  that  the  definiteness  of  the  detailed 
portion  of  an  entry  shall  be  sacrificed.  One  illustration  will  suf- 
fice. Suppose  a  man  takes,  in  settlement  of  an  account,  his 
debtor's  half-interest  in  a  $10,000  piece  of  real  estate,  therefore 
worth  $5,000,  and  takes  cash  for  the  balance  of  the  debt,  say 
$2,500.  Suppose  now  the  man  buys  from  some  one  else  the  title 
to  the  remainder  of  that  piece  of  real  estate  for  $5,000,  using  in 
part  the  cash  received  from  his  debtor,  which  pays  for  one-half 
of  what  he  buys,  or  one-fourth  of  the  whole  property.  He  would 
be  very  foolish  to  record  that  he  had  received  three-fourths  of 
that  property  from  his  debtor  (though  he  did  receive  one-half  and 
cash  enough  to  buy  another  fourth)  and  had  bought  the  other  one- 
fourth  from  the  other  owner.  Such  abbreviation  would  save  one 
entry,  but  it  would  falsify  the  record.  If  the  deeds  should  be  lost 
before  they  were  recorded,  and  it  were  shown  that  the  debtor 
never  owned  more  than  one-half  of  the  property  in  question,  the 
buyer's  books  would  militate  against  him  in  his  claim  to  the  whole 
property.  They  would  indicate  that  he  had  bought  from  the 
last  seller  but  one-quarter  of  the  property  and  from  his  debtor 


THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES  1 75 

three-quarters,  or  more  than  the  debtor  owned.  Transactions 
which  are  for  any  reason  distinct  must  not  be  combined  in  a  way 
that  will  destroy  their  identity. 

Loose-Leaf  Books.  It  is  obvious  that  the  use  of  loose-leaf 
books,  particularly  with  carbon  reproductions  and  adding-ma- 
chine  slips,  may  much  simplify  bookkeeping  labor.  If,  for  ex- 
ample, all  bills  for  customers  are  made  on  a  typewriting  machine 
with  an  adding  attachment,  and  carbon  copies  are  made,  one 
writing  will  provide  both  the  bill  and  the  loose-leaf  entry  sheet 
(to  say  nothing  of  further  copies  for  the  shipping  room,  etc.),  and 
then  an  adding-machine  slip  will  give  the  total  sales  of  the  day 
for  the  summary  record  —  the  debit  to  Accounts  Receivable  and 
the  credit  to  Sales.  Then  the  adding-machine  slip  may  be  per- 
manently filed  as  the  supporting  document  for  a  journal  entry 
covering  the  summary  of  the  day's  sales;  or  if  sales  of  many  de- 
partments are  distinguished,  a  sales  book  with  a  single  entry  a 
day  can  show  the  sales  of  each  day  for  each  department  in  a 
special  column,  and  the  total  of  the  columns  can  serve  as  a  sum- 
mary entry  for  posting  daily,  weekly,  or  monthly,  as  desired. 
It  is  preferable  to  have  such  summary  entries  in  bound  books,  for 
then  the  loose-leaf  books  are  tied  up  with  a  book  so  much  more 
permanent  that  the  danger  of  forgery,  or  suspicion  of  forgery,  is 
more  remote. 

QUESTIONS  AND  PROBLEMS 

1.  Enter  the  following  transactions  in  a  special-column  journal,  using 
special  columns  wherever  it  seems  desirable.  ^  Post  the  entries  to  the 
ledger  and  take  a  trial  balance. 

The  proprietor  invests  $15,000  worth  of  merchandise  and  $5,000  in 
cash. 

Rent  is  paid,  $200;  postage,  $120;  stationery,  $50. 

Goods  are  sold  to  Bay,  $1,000;  Gay,  $800;  Way,  $2,000;  to  cash  cus- 
tomers, $1,500. 

Wages  are  paid,  $200. 

Cash  is  received  from  Bay,  $1,000;  Gay,  $800;  Way,  $1,000. 

The  proprietor  withdraws  $100  for  his  personal  use. 

2.  Enter  the  following  transactions  in  appropriate  books,  post,  and  take 
a  trial  balance.  1 

1  Since  but  few  items  are  given  for  the  purposes  of  this  problem,  all  items  of 
expense  should  be  combined  into  one  expense  account. 


176  THE  FUNDAMENTALS  OF  ACCOUNTING 

J.  Ham,  a  lawyer  and  notary  public,  starts  an  office  to  carry  on  his 
profession.    He  invests  $10,000  in  cash. 

Office  equipment  is  bought  for  $2,000,  supplies  for  $300,  and  law 
books  for  $6,000  —  all  for  cash. 

Notary  fees  are  collected,  $25. 

Bills  for  legal  services  are  sent  out  as  follows:  R.  Stone,  $250; 
J.  Wood,  $100;  K.  Sands,  $300;  L.  Waters,  $500. 

Notary  fees  are  collected,  $43. 

Rent  is  paid  for  one  month,  $150;  salary  to  a  stenographer  is  paid 
for  one  week,  $20;  stamps  are  bought,  $15. 

L.  Waters  and  J.  Wood  pay  their  bills  in  cash.    R.  Stone  gives  a  note 
for  his  bill,  payable  in  60  days  with  interest  @  6%. 
3.  Enter  the  following  transactions  in  the  appropriate  books,  post  to  the 
ledger,  find  and  show  on  the  ledger  the  profit,  transfer  the  profit  to  the 
proprietor's  account,  and  draw  up  the  balance  sheet.  ^ 
The  following  balances  are  already  on  the  ledger. 


Cash 

Equipment 

Expense 

Purchases 

Accounts  Receivable 

$1,200 

250 

300 

4,500 

3,000 

$9,250 

Proprietor 
Accounts  Payable 

$7,000 
2,250 

$9,250 

Merchandise  is  bought  on  account  from  Vesey  &  Co.,  $2,000;  $240 
is  received  for  accounts  receivable;  rent  is  paid  for  one  month,  $75. 

Mdse.  is  sold  for  cash,  $500.  Postage  and  stationery  are  purchased 
for  cash,  $50.  Salaries  are  paid  for  one  week,  $36;  cash  is  paid  on  ac- 
counts payable,  Vesey  &  Co.,  $2,000.  Mdse.  is  sold  on  account  to  John 
Green,  $400,  and  to  Ronald  &  Son,  $600. 

Mdse.  is  bought  for  cash,  $1,000.     Accounts  receivable  are  paid 

$1,500- 

Ronald  &  Son  give  an  automobile  for  their  bill.  The  proprietor  takes 
this  for  his  personal  use.     Cash  is  found,  $10. 

The  inventory  of  merchandise  at  the  end  is  $6,500.  Expense  inven- 
tory is  $275.    Wages  liability  is  $36. 

From  what  actual  sources  should  you  expect  to  find  posted  the  items 
expressed  in  the  tentative  entry  below?  Show  how  the  items  posted 
will  look  in  the  sources  from  which  they  are  posted. 

Cash  15,000 

Merchandise  78,000 

Accounts  Receivable  31,000 

To  Proprietor  A  100,000 

Accounts  Payable  24,000 

To  enter  on  the  books  the  assets  and  liabilities  brought  into  the 
business  by  A,  who  is  consolidating  his  business  with  this. 

»  See  note  on  page  175. 


THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES        1 77 

What  books  of  original  entry  similar  to  those  already  discussed  should 
you  use  for  a  firm  of  architects  maintaining  a  staff  which  engages  in  the 
following  activities:  (i)  drafting  plans,  (2)  supervising  the  construction 
of  buildings  planned,  (3)  writing  articles  for  architectural  magazines? 
Show  in  skeleton  form  the  books  of  original  entry  with  appropriate 
special  columns,  and  enter  in  the  books  the  following  transactions. 
Show  what  is  to  be  posted  from  each  book. 

(a)  Bills  are  sent  out,  made  up  as  follows:  Jones,  drafting  expense 
$200,  supervision  $45,  other  expenses  $10,  margin  of  gross 
profit  $200,  total  charge  $4551  Smith,  drafting  expense  $500, 
supervision  $300,  other  expenses  $5,  margin  of  gross  profit  $400, 
total  charge  $1,205;  Brown,  drafting  expense  $75,  margin  of 
gross  profit  $50,  total  charge  $125. 

(b)  Cash  is  received  as  follows:  for  professional  advice,  $100;  on 
account  from  Jones,  $455;  from  the  Architectural  Age  for  articles, 
$100;  on  account  from  Brown,  $125;  from  The  Builder,  for  articles, 
$200;  investment  of  proprietor,  $1,000. 

(c)  Cash  is  paid  as  follows:  for  wages  to  Roundy  for  supervising, 
$50;  for  wages  to  Blunt  for  supervising,  $30;  for  wages  to  White 
for  drafting,  $60;  for  wages  to  Whiting  for  drafting,  $75;  foi 
postage,  $25;  for  personal  use  of  proprietor,  $100. 


CHAPTER  XII 

THE  PRINCIPLES  OF  LABOR-SAVING  DE\TCES  IN  LEDGERS 

Subordinate  Ledgers.  We  have  so  far  spoken  of  Accounts  Re- 
ceivable and  Accounts  Payable  as  chiefly  sources  of  information 
for  the  balance  sheet,  and  this  is  quite  correct.  A  little  thought, 
however,  will  show  that  something  more  than  information  for  the 
balance  sheet  is  needed  in  connection  with  the  substance  which 
these  accounts  represent.  If  a  man  knows  that  a  certain  number 
of  thousand  dollars  are  owed  him  but  he  does  not  know  who  owes 
him  those  dollars,  he  is  in  a  fair  way  to  lose  more  of  them  than  he 
would  be  if  he  knew;  and  if  he  knows  that  he  himself  owes  a  num- 
ber of  thousand  dollars  but  does  not  know  whom  he  owes,  his 
credit  will  unquestionably  suff'er.  Information  about  debts  ow- 
ing and  owed  should  be  systematized.  The  obvious  suggestion 
is  that  we  make  use  of  the  ledger  for  all  such  information  and  open 
a  ledger  account  with  each  person  who  owes  us  and  each  person 
to  whom  we  owe  anything.  In  fact,  in  small  businesses  that  is 
what  is  done;  and  several  or  many  accounts  take  the  place  of  the 
one  Accounts  Receivable,  and  several  or  many  others  take  the 
place  of  the  one  Accounts  Payable.  In  preparing  figures  for  the 
balance  sheet,  then,  the  sum  of  the  balances  of  the  accounts  of  all 
debtors  is  called  Accounts  Receivable,  as  if  they  were  all  in  one 
account,  and  the  sum  of  the  balances  of  the  accounts  of  all  credi- 
tors is  called  Accounts  Payable.  This  works  very  well  in  small 
businesses.  When,  however,  the  number  of  customers  runs  into 
hundreds,  or  thousands  as  it  does  in  many  large  businesses,  or 
even  into  the  hundreds  of  thousands  as  it  does  in  a  few,  the  task 
of  finding  the  amounts  owing  requires  some  other  method  than 
that  just  mentioned  if  information  is  desired  often  and  promptly. 
Indeed,  getting  figures  for  Accounts  Receivable  and  Accounts 
Payable  at  long  intervals  will  not  serve  in  businesses  too  large  to 
be  watched  at  first  hand  by  the  managers.  Such  managers  must 
have  frequent  reports  of  condition,  and  often  accounts  receivable 
and  accounts  payable  are  important  elements  in  such  reports. 
Obviously  the  preparation  of  such  reports  would  be  unduly  labo- 


THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES        I79 

rious  if  the  figures  could  be  got  only  by  finding  hundreds  of  bal- 
ances of  individual  accounts  and  then  adding  them  together. 
The  thing  to  do  suggests  itself.  We  can  have  an  account  in  the 
ledger  for  all  accounts  receivable  in  a  bunch  or  group,  just  as  if 
all  were  receivable  from  one  man  (and  as  we  have  so  far  treated 
them),  and  then  we  can  keep  details  of  the  bunch  or  group  in  a 
subordinate  ledger,  which  shall  show  how  much  of  the  group  total 
is  owed  by  each  member  of  the  group.  Such  a  subordinate  ledger 
for  accounts  receivable  is  commonly  called  a  ''sales  ledger,"  or 
** customers  ledger,''  and  for  accounts  payable  is  called  a  "pur- 
chase ledger,''  or  "creditors  ledger." 

The  Bookkeeping.  This  would  be  laborious  if  it  involved  a 
posting  for  each  entry  to  both  the  group  account  and  the  individ- 
ual account,  doubling  the  labor;  but  we  have  already  seen  that 
this  is  not  required.  We  have  already,  by  the  use  of  special 
columns,  found  a  way  of  carrying  to  the  ledger  all  items  of  ac- 
counts receivable  for  a  whole  period  in  one  posting.  It  makes 
no  difference  whether  our  period  is  a  day  or  a  week  or  a  month: 
we  can  post  the  total  for  that  period  from  the  total  of  the  special 
column  for  that  account.  If,  in  addition,  we  need  to  know  in 
ledger  form  what  is  owed  us  by  each  individual  of  the  group,  we 
establish  a  group  ledger,  and  post  each  item  to  the  appropriate 
individual  account  in  that  ledger.  Then  the  simi  of  the  balances 
of  all  accounts  in  the  group  ledger  must  be  identical  with  the  bal- 
ance of  Accounts  Receivable  in  the  general  ledger,  for  the  two 
consist  of  the  same  thing  —  one  posted  in  small  pieces  to  the  sub- 
ordinate ledger,  and  the  other  posted  in  gross  to  the  general  ledger. 
Then  the  general  manager  can  watch  gross  figures  from  the  fre- 
quent reports  of  Accounts  Receivable  of  the  general  ledger,  and 
the  collection  manager  can  watch  details  from  the  subordinate 
ledger.  On  page  171  we  have  an  illustration  of  this  principle,  ex- 
cept that  it  is  applied  to  accounts  payable  rather  than  to  accounts 
receivable.  In  the  form  shown,  the  total  of  the  column  is  obvi- 
ously posted,  for  the  ledger  folio  is  given;  but  no  folio  appears 
opposite  the  name  of  Smith  or  of  Jones.  If  we  are  to  maintain 
the  subordinate-ledger  system  just  described,  we  must  post  credits 
to  their  accounts  in  the  subordinate  ledger  and  indicate,  by  using 
as  a  posting  check  the  ledger-folio  number  of  their  accounts  in 


l8o  THE  FUNDAMENTALS  OF  ACCOUNTING 

that  ledger,  the  fact  that  posting  has  been  made.  No  special 
notation  needs  to  be  made  of  the  fact  that  their  ledger-folio  nimi- 
bers  are  for  the  subordinate  ledger,  for  the  presence  of  the  amounts 
in  the  Accounts  Payable  column  sufficiently  indicates  that  fact; 
but  for  convenience  in  posting,  the  names  of  Smith  and  Jones 
should  appear  in  the  joumaHzation  colimin;  and  the  words  "Ac- 
counts Payable  ^'  may  be  omitted  from  the  detailed  entry. 

Controlling  Accounts.  Historically  we  have  gone  backwards 
in  our  treatment  of  subordinate-ledger  accounts.  In  the  days  of 
less  developed  bookkeeping  method,  there  were  no  subordinate 
ledgers.  All  accounts  were  kept  in  the  one  ledger.  Then  with 
the  need  of  prompt  and  frequent  statistical  report  of  debts  owed 
and  owing,  the  plan  was  evolved  of  omitting  from  the  ledger 
details  regarding  debtors  and  creditors  and  substituting  an  ac- 
count for  the  whole  group  of  each,  and  relegating  the  details  to  a 
supplementary  ledger  such  as  has  been  described.  The  group 
account  in  the  general  ledger  is  called  a  *' controlling  account," 
because  it  "controls"  the  subordinate  ledger  in  the  sense  that  one 
who  has  figures  for  the  controlling  account  knows  what  the  sum  of 
the  others  must  be  —  that  is,  he  has  the  key  in  his  own  hands.  It 
is  obvious  that  great  care  must  be  taken  that  no  entries  are  ever 
made  to  a  subordinate-ledger  account  without  provision  for  a  sim- 
ilar debit  or  credit  to  the  controlling  account,  and  no  entry  must 
ever  be  made  to  the  controlling  account  without  provision  for 
similar  debit  or  credit  to  the  proper  subordinate-ledger  accoimt. 
Indeed,  a  realization  of  this  is  at  the  basis  of  the  whole  plan.  If  a 
change  is  to  be  made  in  the  controlling  accoimt  it  is  because,  and 
only  because,  a  change  must  be  made  in  a  subordinate-ledger  ac- 
count. A  transaction  can  never  originate  in  connection  with  a 
controlling  accoimt,  for  the  controlling  account  represents  no 
entity.  The  entity  is  in  what  is  represented  by  the  subordinate- 
ledger  account;  and  that  account  is  subordinate  only  in  the  book- 
keeping sense  —  kept  in  a  minor  book  for  convenience,  not  en- 
tered on  the  balance  sheet,  but  actually  representing  the  real 
thing  for  which  a  group  account  is  substituted  in  the  general 
ledger  and  the  balance  sheet. 

The  Subordinate-Ledger  Abstract.  As  a  check  on  the  parallel- 
ism between  the  controlling  account  and  the  subordinate  ledger 


THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES        l8l 

which  it  controls,  occasional  comparisons  should  be  made.  Such 
a  test  consists  in  listing  the  balances  of  all  subordinate-ledger  ac- 
counts, taking  the  total  of  those  balances,  and  comparing  that 
total  with  the  balance  of  the  controlling  account.  If  the  two 
figures  are  not  in  agreement,  error  has  crept  in  somewhere  and 
must  be  found  and  corrected.  This  should  be  done  often  enough 
to  give  assurance  that  if  discrepancy  is  found  it  will  not  be  so  old, 
or  consisting  of  so  many  errors,  that  detection  and  correction  will 
cost  more  than  more  frequent  tests  would  cost.  Errors  should  be 
found,  for  a  small  discrepancy  may  be  the  net  result  of  many 
large  errors  which  to  great  extent  offset  each  other  in  figures  but 
may  not  correct  each  other  in  actual  assets  and  liabilities  —  on 
the  books,  e.g.,  a  debit  to  one  customer  may  look  as  good  as  a 
debit  to  another,  but  one  cannot  usually  collect  on  wrong  debits. 
When  Controlling  Accounts  are  Worth  While.  It  is  obvious 
that  so  far  as  pure  bookkeeping  labor  is  concerned  the  use  of  con- 
trolling accounts  makes  more  rather  than  less  work,  for  besides 
all  the  postings  to  the  individual  accounts  in  the  subordinate 
ledgers  a  few  postings  have  to  be  made  to  the  controlling  accounts. 
It  may  seem  strange,  therefore,  to  speak  of  controlling  accounts 
among  labor-saving  devices.  One  must  realize  why  accounts  are 
kept:  they  are  kept  not  for  their  own  sake,  but  for  the  information 
which  they  can  give.  They  must  be  used  to  have  value.  A  list 
of  individual  sums  due  to  a  business  is  ol  httle  value  to  the  general 
manager  unless  he  can  learn  the  total,  learn  how  fast  collections 
are  made,  learn  how  much  he  is  owing  on  accounts  payable,  learn 
how  much  cash  he  has,  and  see  what  his  financial  policy  should  be. 
The  head  of  a  large  active  business,  not  coming  into  intimate  per- 
sonal contact  with  all  the  activities,  must  rely  largely  on  reports 
made  to  him  by  others  —  particularly  his  accountant.  He  can- 
not use  detailed  figures  to  advantage,  and  therefore  somebody 
must  provide  for  him  total  figures;  and  when  the  business  is  large 
he  must  watch  many  figures  daily  or  weekly.  Is  it  easier  to  com- 
bine the  detailed  figures  of  accounts  receivable  into  one  total  by 
adding  together  the  individual  items,  or  is  it  easier  to  keep  them 
always  in  a  controlling  account  ready  for  instant  use?  That  is 
the  whole  question  with  regard  to  the  advantage  of  controlling 
accoimts.    A  controlling  accoimt  is  worth  while  as  soon  as  any 


l82  THE  FUNDAMENTALS  OF  ACCOUNTING 

group  of  items  is  so  large,  and  so  important,  that  the  task  of  com- 
bining the  details  from  individual  accoimts  into  a  total  or  balance 
as  often  as  the  figure  is  needed  for  the  guidance  of  the  manager 
is  more  laborious  than  would  be  the  keeping  of  a  controlling  ac- 
count in  addition  to  the  individual  accoimts  (which  are  relegated 
to  a  subordinate  ledger)  —  and,  as  we  have  seen,  the  task  of  keep- 
ing a  controlUng  account  is  not  great. 

Extension  of  the  Principle.  This  principle  is  applicable  for 
other  things  than  accounts  receivable  and  accounts  payable.  If, 
for  example,  a  manager  wishes  to  watch  carefully  his  expenses, 
not  in  detail  but  in  total,  and  to  have  minute  details  of  subdivision 
of  expense  watched  by  superintendents,  it  would  be  desirable  to 
establish  a  controlling  account  for  expenses  as  a  whole  in  the 
general  ledger  and  carry  the  detailed  expenses  to  a  subordinate  ex- 
pense-ledger. The  same  sort  of  thing  can  be  done  in  a  manufac- 
turing business  by  confining  detailed  accounts  of  factory  adminis- 
tration to  a  subordinate  ledger  called  the  "factory  ledger,"  and 
keeping  a  controlling  account  in  the  general  ledger  to  represent 
it,  commonly  called  "Factory  Ledger."  Individual  shipments 
of  merchandise  to  be  sold  on  commission  can  be  controlled 
through  a  controlling  Shipments.  There  is  no  limit  to  the  ex- 
tension of  the  principle  except  that  of  convenience  —  detailed 
accounts  needing  frequent  observation  as  a  group  and  sufficient 
in  number  to  make  a  group  account  preferable  to  the  frequent 
gathering  together  of  details  from  the  individual  accoimts. 

The  Subdivision  of  Controlling  Accounts.  A  corollary  of  the 
principle  of  controlling  accounts  is  worth  observation.  Fancy 
yourself  trying  to  get  your  abstract  of  accounts  receivable  taken 
from  a  hundred  thousand  sales-ledger  balances.  If  you  found  a 
discrepancy,  where  should  you  begin  to  hunt  for  the  error?  The 
error  may  be  in  the  mere  addition  of  the  balances  to  get  the  total, 
or  in  the  figuring  of  the  balances  on  the  subordinate  ledger,  and 
the  subordinate  ledger  itself  may  be  right  —  in  other  words,  the 
error  may  be  in  the  test  itseK.  Of  course,  too,  either  of  the 
ledgers  can  have  an  error,  a  careless  or  an  omitted  posting. 
In  attempting  to  detect  the  error,  one  would  naturally  first 
check  up  the  addition  of  the  ledger  balances,  then  the  figuring 
of  the  balances,  and  then  if  the  error  were  not  found  check  up  the 


THE  PRINCIPLES  OF  LABOR-SAVING  DEVICES        1 83 

postings  to  both  the  general  and  the  subordinate  ledger.  In 
other  words,  nothing  of  the  original  test  can  be  deemed  to  be 
satisfactory  until  it  has  been  done  again  or  the  error  has  been 
found;  and  hence  the  whole  test  must  be  gone  over  unless  the 
error  is  found  sooner.  This  is  discouraging.  If  the  test  can  be 
made  piecemeal  and  each  piece  be  judged  by  itself,  only  the  pieces 
that  fail  to  prove  correct  at  the  first  trial  need  be  done  a  second 
time.  Now  that  the  principle  of  the  controlling  account  is  avail- 
able, such  piecemeal  tests  are  possible.  Suppose  instead  of  one 
controlling  account  for  the  hundred  thousand  accoimts  we  have 
ten  controlling  accounts  and  ten  sales  ledgers,  for  approximately 
ten  thousand  accoimts  each.  Suppose  we  put  into  Sales  Ledger 
#1  all  accounts  of  customers  whose  surname  initials  are  A  or  B, 
into  Sales  Ledger  #2  all  whose  initials  are  C  or  D,  into  Sales 
Ledger  #3  all  whose  initials  are  E,  F,  or  G,  etc.  Then  the  bal- 
ance of  Accounts  Receivable  Account  #1  must  agree  with  the 
sum  of  the  balances  of  all  accounts  in  Sales  Ledger  #1.  If  it  does 
agree,  we  have  no  further  concern  with  that  subdivision  of  our 
Accounts  Receivable,  but  will  hunt  for  discrepancies  in  those 
accounts  only  for  which  the  agreement  is  not  found.  This  makes 
it  possible  to  keep  agreement  between  the  subordinate  ledgers 
and  the  controlling  accounts  in  businesses  which  are  so  large 
that  errors  would  possibly  never  be  found  if  there  were  no  piece- 
meal comparison  —  for  new  errors  might  creep  into  work  of  such 
magnitude  faster  than  old  errors  could  be  detected. 

Other  Labor-Saving  Devices.  Nmnerous  devices  for  saving 
labor  in  connection  with  ledgers  have  a  double  labor-saving  as- 
pect, for  they  combine  in  ingenious  ways  original  entries  and 
postings.    These  are  discussed  in  the  next  chapter. 

QUESTIONS  AND  PROBLEMS 
I.  The  statement  below  shows  balances  on  ledger  accounts. 

Cash  $1,250        Proprietor  $8,650 

Merchandise  8,500        Accounts  Payable  3,Soo 

Accounts  Receivable  2,300  Kuhn  Bros.         $2,000 

Morris  $1,200  Hohnes  &  Son       1,500 

Marsh  830 

Fuller  270 

General  Expense  100  

$12,150  $12,150 


184  THE  FUNDAMENTALS  OF  ACCOUNTING 

Enter  the  following  transactions  in  the  journal,  cash  book,  purchase 
book,  and  sales  book;  post  to  the  appropriate  ledgers;  take  a  trial 
balance  of  the  general  ledger  and  abstracts  of  the  sales  and  purchase 
ledgers. 

We  buy  on  account  from  Short  Co.  merchandise  costing  $1,200,  and 
from  Long  Brothers  merchandise  costing  $530. 

Morris  pays  his  bill  and  buys  on  account  $1,200  more  of  merchandise. 

We  pay  Holmes  &  Son  $1,000  on  account. 

Sales  are  made  to  D.  Blanchard  for  cash  $50,  to  Stickney  &  Son  on 
account  $1,200,  to  Ross  Brothers  $1,000  of  which  $500  is  paid  in  cash. 

Purchases  for  $5,000  are  made  from  Montgomery  Bros,  on  account. 

Purchases  are  made  for  cash  at  an  auction,  $500. 

Wages  are  paid,  $126;  supplies  are  purchased,  $50;  postage  is  pur- 
chased, $25;  express  is  paid,  $7.  The  proprietor  withdraws  $50  for  his 
personal  use. 

Marsh  pays  his  bill;  Fuller  pays  $70  on  account. 

2.  The  manager  of  a  business  has  given  up  all  hope  of  collecting  the  ac- 
count of  Jay  Kay  &  Co.  (in  Sales  Ledger  B),  and  of  Zee  &  Co.  (in  Sales 
Ledger  D),  and  of  collecting  on  the  promissory  note  of  A.  Bee  &  Co. 
He  orders  the  bookkeeper  to  write  off  these  assets  as  worthless,  (a) 
What  entries  should  be  made  in  what  books?  (b)  Six  months  later  all 
these  firms  pay  their  obligations  in  full.  What  entries  should  be  made? 
(c)  Would  the  entries  be  different  in  any  case  if  the  business  had  been 
carrying,  previous  to  the  writing-off,  an  account  called  Allowance  for 
Bad  Debts?  If  so,  make  the  entries  and  indicate  for  which  of  your 
other  entries  they  would  be  substituted. 

3 .  Would  it  be  possible  to  have  a  controlling  account  for  cash?  If  so,  imder 
what  circumstances?    If  not,  why  not? 


^^J^3>- 


1^' 


CHAPTER  Xm 

SOME  HIGHLY  DEVELOPED  LABOR-SAVING  DEVICES 

Mere  Technique.  The  matters  of  this  chapter  are  not  matters 
of  principle  but  of  bookkeeping  technique,  and  hence  are  not  of 
interest  to  persons  concerned  only  with  the  larger  aspects  of  ac- 
counting. They  are,  however,  important  for  all  who  are  con- 
cerned with  efficient  gathering  of  accounting  figures,  for  the  fun- 
damental devices  described  in  the  preceding  two  chapters  are 
capable  of  high  development  of  interest  to  accountants,  treasur- 
ers, office  managers,  auditors,  and  other  officials  responsible  for 
the  general  supervision  of  books  of  account.  The  devices  de- 
scribed below  are  chosen  not  so  much  for  their  own  intrinsic  im- 
portance as  because  they  are  typical  and  suggest  how  original 
devices  may  be  developed. 

Lines  of  Division  Between  Books.  We  have  already  seen  that 
the  cash  book,  the  purchase  book,  and  the  sales  book  are  but  con- 
venient subdivisions  of  the  journal.  It  is  obvious,  then,  that  the 
lines  of  division  need  be  only  as  hard  and  fast  as  convenience  re- 
quires. If  we  have  taken  out  of  the  journal  all  cash  items  and 
put  them  into  a  special  book,  we  may  equally  well  take  out  along 
with  the  cash  items  other  items  which  may  be  conveniently 
handled  with  them.  The  best  illustration  of  this  is  cash  dis- 
counts. 

CASH  DISCOUNTS 

The  Entry.  As  we  have  already  seen  in  Chapter  VIU,  it  is 
common  in  many  lines  of  business  to  offer  a  discount,  or  reduction 
in  the  amount  of  a  bill,  if  the  bill  is  paid  promptly  —  say  3%  if 
the  bill  is  paid  in  ten  days.  The  customer  is  charged  for  the  full 
amoimt  of  the  bill  when  the  goods  are  sold,  for  the  seller  does  not 
know  whether  the  discount  will  be  taken  or  not.  When  he  pays, 
therefore,  he  must  be  credited  for  the  full  amoimt  of  the  bill  even 
though  he  pays  less  by  the  amoimt  of  the  discount.  At  the  time 
of  pajonent.  Cash  must  be  debited  for  the  cash  payment.  Dis- 
count Given  must  be  debited  for  the  amount  of  the  discount,  and 


1 86  THE  FUNDAMENTALS  OF  ACCOUNTING 

the  customer  (and  Accounts  Receivable)  must  be  credited  for  the 
full  amount  of  the  bill.  If  we  were  to  adhere  rigidly  to  the  prin- 
ciple of  having  only  cash  in  the  cash  book,  we  should  have  to  split 
this  entry  between  two  books,  a  debit  to  Cash  and  a  credit  to  the 
customer  in  the  cash  book,  and  a  debit  to  Discoimt  Given  and  a 
credit  to  the  customer  in  the  journal.  This  means  two  postings 
to  the  customer's  account.  By  putting  the  discoimt  as  well  as 
the  cash  into  the  cash  book,  however,  we  can  credit  the  customer 
by  one  posting.  If,  on  the  other  hand,  we  wish  the  customer's 
ledger  account  to  show  whether  he  took  his  discount,  as  summary 
information  for  the  credit  manager,  we  must  post  the  items  sepa- 
rately to  his  account;  but  even  then  it  is  worth  while  to  have  the 
discount  in  the  cash  book,  for  one  explanation  will  do  for  both 
postings  and  both  may  be  posted  from  the  same  book.  Many 
arrangements  of  the  cash  book  for  this  purpose  are  in  use,  and  as 
they  are  typical  of  the  flexibility  of  bookkeeping  form,  they  are 
worthy  of  observation;  indeed,  they  comprise  one  of  the  best  illus- 
trations that  can  be  given  of  flexibility,  and  hence  students  of 
bookkeeping  may  well  study  them  with  care  and  compare  them 
critically. 

With  Contra  Items.  A  commonly  used  and  acceptable  princi- 
ple allows  an  overstatement  of  any  account  provided  the  over- 
statement is  carried  to  both  sides  of  the  accoimt  and  provided  the 
actual  total  is  not  of  value  for  statistical  purposes.  There  is  little 
value,  for  example,  in  the  total  of  the  cash  account,  for  it  does  not 
represent  anything  that  the  manager  cares  about.  It  is  a  result  of 
so  many  things  that  it  measures  no  one  thing:  balances  only  are 
what  count  with  respect  to  it.  No  harm  is  done,  then,  if  we  exag- 
gerate cash  receipts,  provided  we  at  the  same  time  (leaving  no 
margin  of  time  for  a  false  conclusion  about  the  cash  balance) 
equally  exaggerate  the  cash  disbursements:  that  is,  if  we,  for  con- 
venience in  bookkeeping,  report  more  money  as  coming  in  than 
really  came  in  and  at  the  same  time  report  the  same  excess  as 
going  out,  no  harm  is  done  provided  this  double  (compensating) 
error  has  not  affected  any  other  account.  We  have  seen  that  to 
have  the  complete  record  of  the  payment  of  bills  by  customers  all 
in  one  place,  rather  than  divided  between  two  books,  would  be  a 
saving  of  labor  in  both  escplanation  and  posting.    If  we  treat  the 


LABOR-SAVING  DEVICES 


187 


bill  as  if  paid  in  cash  in  full  even  though  a  discount  is  taken  by  the 
customer,  and  then  make  another  entry  as  if  we  had  given  him 
his  discount  in  cash  instead  of  deducting  the  amount  from  the  face 
of  his  bill,  we  shall  get  the  same  effect  in  the  end  and  make  our- 
selves less  work.  Suppose  a  bill  is  for  $600,  but  the  customer  by 
paying  early  is  entitled  to  a  discount  of  5%,  or  $30.  He  will  actu- 
ally pay  $570  in  cash.  Theoretically,  we  should  debit  Cash  $570, 
debit  Discount  Given  $30,  and  credit  the  customer  (and  Accounts 
Receivable)  $600.  If  we  confine  our  cash  book  strictly  to  cash 
entries,  we  shall  on  the  cash  book  credit  the  customer  (and  Ac- 
coxmts  Receivable)  $570,  and  debit  Cash  for  the  same  amount, 
and  shall  on  the  journal  debit  Discount  Given  $30  and  credit  the 
customer  (and  Accounts  Receivable)  $30.  If,  on  the  other  hand, 
we  enter  on  the  receipts  side  of  the  cash  book  the  whole  $600, 
crediting  the  customer  (and  Accounts  Receivable)  and  debiting 
Cash,  of  course,  and  then  on  the  disbursements  side  of  the  cash 
book  debit  Discount  Given  and  credit  Cash,  we  shall  have  the 
correct  credit  to  the  customer,  the  correct  debit  to  Discount 
Given,  and  the  correct  balance  of  debit  to  Cash  (but  not  the  cor- 
rect total  of  cash  on  either  side) .  We  have  represented  just  what 
would  have  happened  if  the  customer  had  neglected  to  take  off 
his  discount  and  then  we  had  sent  him  a  check  to  correct  the  error. 
This  is  for  practical  purposes  proper  bookkeeping,  though  theo- 
retically not  quite  truthful  in  detail,  and  actually  truthful  in  net 
effect.  This  is  illustrated  below  by  two  such  transactions  —  the 
first  a  cash  receipt  as  just  described,  and  the  other  a  cash  payment 
on  a  bill  for  $1,000  with  a  discount  allowed  of  5%,  or  $50.00. 

Cash  Receipts 


B.  Sykes 
Discount  Taken 
Accounts  Receivable 
Cash,  Dr. 


Discount  Given 
Adam  Bede 
Accounts  Payable 
Cash,  Cr. 


Invoice,  12/1,  Pd. 
A.  Bede,  5%,  contra 


Cash  Disbursements 


B.  Sykes,  s%.  contra 
Invoice,  za/^*  Pd. 


Accis. 
Receivable 

600 

00 

SO 
600 
650 

600 

00 

Accts. 
Payable 


1,000 
1,000 


30 
1,000 


I1O30 


i88 


THE  FUNDAMENTALS  OF  ACCOUNTING 


The  net  result  here  is  a  decrease  of  cash  by  $380,  or  the  difference 
between  $650  debits  and  $1030  credits,  though  the  actual  cash 
received  was  but  $570  and  that  disbursed  was  $950,  again  a  differ- 
ence of  $380.  This  form  has  still  an  awkwardness  in  making  en- 
tries, however.  The  cash  payment  and  the  discount  go  on  oppo- 
site sides  of  the  cash  book,  and  each  must  be  explained  fully 
enough  to  identify  it  —  the  same  transaction  twice  explained.  We 
should  like  to  avoid  this  duplication.  Let  us  see  whether  by  a 
new  use  of  the  special  column  we  can  put  both  parts  of  the  trans- 
action on  the  same  side  of  the  cash  book.  We  have  so  far  used 
the  special  colimin  as  a  device  for  holding  up  temporarily  certain 
items  and  then  posting  them  in  a  lump  sum.  We  may  use  it  also, 
obviously,  for  other  similar  purposes,  such  as  transferring  items  to 
the  other  side  of  a  cash  book.  If,  then,  we  enter  the  discounts  on 
the  same  side  of  the  cash  book  with  the  payments  (even  though 
they  represent  the  amounts  not  paid),  we  can  transfer  them  in 
lump,  or  total,  to  the  other  side  of  the  cash  book  whenever  we 
wish  to  post  items.  In  order  to  observe  this,  let  us  take  a  larger 
number  o!  items  than  in  our  previous  illustration,  including  some 
of  a  different  nature,  start  with  a  cash  balance,  and  close  the  cash 
book.  It  will  be  noted  in  the  form  following  that  the  discount 
taken  by  Sykes  is  entered  on  the  receipts  side  of  the  cash  book, 
though  it  was  not  received  but  given,  and  the  total  of  the  column 
in  which  it  stands  is  at  the  end  of  the  period  carried  to  the  other 
side  of  the  cash  book,  there  to  increase  the  Cash  credits  as  much 
as  the  inclusion  of  the  discount  here  in  the  $600  has  increased  the 
Cash  debits.  So  the  exaggeration  of  Cash  debits  is  offset  by  an 
exaggeration  of  Cash  credits. 

Receipts 


Jan.  I 


Balance 

Bills  Receivable 
B.  Sykes 
B.  Patterson 

Accts.  Receivable 
Discount  Taken 
Cash,  Dr. 


Balance 


3>354 

27 

#67  Paid 

Invoice,  la/i,  s%  Pd. 

Invoice,  12/1,  5%,  Pd. 

Discount  contra 

Contra 

3.777 

60 

6.131 

87 

1,360 

sT 

Accts 

.  Receivable 

Total 

Dis- 
count 

6co 
400 

00 

00 

oo~ 

30 
20 

50 

00 
00 
00 

1,000 

3,70000 


I,OOC 

77 


3,777 


LABOR-SAVING  DEVICES 


189 


Disbursements 


Jan. 


Adam  Bede 
H.  Spring  &  Bro. 
J.  Judson 
Expense 
Bills  Payable 
Expense 

Accts.  Payable 
Discount  Given 
Cash,  Cr. 
Balance 


Invoice,  12/2,  5% 
Invoice,  10/8 
Invoice,  12/26,  6% 
Postage 
#49  Paid 

Discount  coQtra 
Contra 


Accts.  Payable 

Ex- 
pense 

3,000 
IS 

1,706 
SO 

Total 

Discount 

IS 

00 
oo~ 

1,000 

It 

00 
00 
00 

oo~ 

50 
27 

00 
60 

60" 

00 

00 

77 

1,706 

00 

00 

4,771 
1,360 

00 
87 

6,131 

87 

'" 

A  new  slight  awkwardness  now  appears,  for  in  order  to  find  the 
cash  balance  at  any  time  one  must  allow  for  the  fact  that  some 
items  are  on  the  wrong  side  (or,  in  reality,  are  not  cash  items  at 
all).  One  must  either  add  the  total  of  each  discount  column  to 
the  total  of  all  colimins  on  the  other  side  of  the  cash  book,  or  sub- 
tract it  from  the  total  of  all  other  items  on  the  side  where  it  stands. 
To  avoid  this,  some  bookkeepers  substitute  a  *'net"  for  the 
"total"  column  of  the  form  as  shown.  In  this  is  entered  the 
actual  cash  received,  after  deduction  of  discount,  and  then  the 
total  cash  for  the  period  is  the  total  of  each  side  of  the  cash  book 
neglecting  the  discount  columns  altogether.  This  works  well  for 
the  cash,  but  it  makes  some  inconvenience  for  the  accounts  re- 
ceivable. We  now  have  no  figure  ready  for  posting  as  a  credit 
either  to  the  customer,  for  full  settlement  of  his  bill,  or  to  the  con- 
trolling account.  As  a  matter  of  fact,  however,  it  is  well  to  have 
the  cash  part  and  the  discount  part  of  each  settlement  posted 
separately  on  the  customers  ledger,  as  a  matter  for  convenient 
reference,  and  the  credit  to  Accounts  Receivable  may  be  got  as 
the  sum  of  the  net-cash  column  and  the  discount  column.  So 
the  totals  of  these  columns  may  be  added  together  at  the  foot  of 
the  page,  the  sum  extended  into  the  simdries  column,  and,  as  be- 
fore, the  discount  carried  "contra,"  for  it  has  now  been  included 
in  the  cash  items  and  must  be  taken  out  by  transfer  to  the  other 
side. 

Without  Contra  Items.    Now  a  new  possibility  appears.    We 
previously  had  to  treat  the  discounts  as  contra  items  because  we 


I90 


THE  FUNDAMENTALS  OF  ACCOUNTING 


had  treated  the  bills  paid  as  if  paid  by  cash  in  full.  We  now  have 
the  net  cash  shown  separately,  and  therefore  might  as  well  include 
in  our  cash  total  debit  and  total  credit  only  the  cash  actually 
handled  on  either  side  of  the  book.  Then  we  shall  need  no  contra 
items,  or  transfers  to  the  other  side  of  the  cash  book.  Under  this 
method  the  entries  can  be  made  exactly  as  above,  but  the  closing 
will  differ  somewhat.  The  total  of  the  net-cash  column  will  go 
directly  into  the  sundries  column  before  the  addition  of  discounts. 
The  discounts  will  not  now  be  treated  as  cash  items,  but  will  be 
treated  purely  as  journal  entries  having  no  connection  with  cash, 
except  as  involved  in  transactions  in  which  cash  is  also  involved 
in  a  parallel,  not  a  complementary,  way.  The  closing,  repeating 
nothing  above  the  footings  of  the  form  above,  is  then  as  follows: 

Receipts 


Discount  Given,  Dr. 
Accounts  Receivable,  Cr. 
Cash,  Dr. 

Balance 


Net  Cash 


3.650 


6,004 


1.360 


87 


Accts.  Receivable 

Net 
Cash 

Dis- 
count 

1 
950|00 
SO  00 
1,000,00 

~50 

00 

050 


3,650 


Disbursements 


Expense,  Dr. 

Discount  Taken,  Cr. 
Accounts  Payable,  Dr. 

Cash,  Cr. 
Baianu 


Net  Cash 


Accts.  Payable 

Net 
Cash 

Discount 

40 
60 

77 

60 

1,628 
77 

1.706 

00 

Ex. 

Pense 


15 
1,638 


4,643 140 
/,j<5o  87 


6,004  27 


The  double  ruling  under  $50.00,  $1,000.00,  $77.60,  and  $1,706.00, 
shows  that  the  items  go  no  farther  —  do  not  go  into  the  sundries 
column,  for  the  net  cash  has  already  been  carried  there.  Other 
devices  serve  similar  purposes,  but  these  are  sufficiently  typical. 
As  suggested  in  Chapter  VIII,  these  forms  may  easily  be  adapted 
to  show  and  provide  postings  for  discounts  forfeited. 


LABOR-SAVING  DEVICES  I9I 

PURCHASE  BOOK,  PURCHASE  LEDGER,  AND  STOCK  BOOK 
COMBINED 

Book  of  Original  Entry  as  Ledger.  One  of  the  time-consuming 
tasks  of  bookkeeping  is  posting.  Under  certain  circumstances 
the  special  column  can  be  applied  farther  than  we  have  yet  ap- 
plied it  and  be  made  to  touch  the  ledger  itself.  If  ledger  accounts 
are  not  too  numerous  and  transactions  are  not  too  varied,  the 
special  column  in  a  book  of  original  entry  may  be  itself  used  as  a 
ledger,  thus  avoiding  the  necessity  of  posting  from  it.  We  shall 
observe  such  a  device  in  the  next  paragraph.  If,  on  the  other 
hand,  even  though  ledger  accoimts  are  numerous,  transactions  are 
few  in  kind,  we  may  reverse  the  process  and  use  the  ledger  itself  as 
a  book  of  original  entry,  as  described  in  the  fourth  paragraph  fol- 
lowing. In  both  of  these  cases,  however,  the  ledger  concerned  is 
subordinate,  for  only  in  extremely  rare  cases  would  a  business  be  so 
simple  as  to  warrant  these  devices  applied  to  the  general  ledger. 

Purchase  Book  and  Purchase  Ledger.  If  the  business  buys 
from  very  few  sources  of  supply,  not  more  than  can  be  conven- 
iently provided  with  a  pair  of  special  columns  for  each,  the  pur- 
chase book  may  provide  its  own  purchase  ledger.  A  controlling 
account  may  then  be  provided  in  the  general  ledger,  not  so  much  to 
save  labor  as  to  give  assurance  that  the  liabilities  for  purchases  will 
not  be  forgotten  in  drawing  up  reports.  Obviously  not  all  entries 
to  the  purchase-ledger  accounts  will  be  found  on  the  purchase  bods, 
however,  for  payments  of  bills  will  be  on  the  cash  book,  and  hence 
some  postings  will  be  necessary  to  these  accounts  from  other  books ; 
but  the  elimination  of  the  credit  postings  is  in  itself  worth  while. 

The  Stock  Book.  In  examining  the  device  just  mentioned,  let 
us  see  how  other  information  may  be  coupled  with  it.  Suppose 
the  business  deals  in  only  a  few  kinds  of  commodities,  that  these 
are  handled  in  large  quantities  or  numbers,  and  that  it  is  conven- 
ient to  keep  perpetual  information  of  the  amount  of  each  item  in 
stock.  By  providing  special  columns  for  each  kind  of  goods, 
entering  in  them  all  purchases  of  each,  and  providing  similar  col- 
umns in  the  sales  book  and  transferring  the  sales  total  of  each  kind 
periodically  to  the  purchase  book  for  subtraction  from  the  pur- 
chases, we  can  show  the  stock  on  hand. 

Other  Facts.    Lastly,  information  about  the  date  when  bills 


8 

1 

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fei 

c$ 

153 

1 

^ 

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Q 

8 

1 

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c3 

§ 

8 

8 

1 

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^ 

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lO       t^ 

» 

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8 

^ 

CJ 

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2 

8 

8 

Cl 

^ 

2 

i 

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i 

44 

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Q 

(K< 

8 

E^ 

4 

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to 

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v8 

U3 

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8 

8 

8 

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8lj 

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p. 

ebits 
cred 

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a    -3, 
^      a 

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w 

Mdse. 
To  A. 

Total  d 
Total 

1 

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w> 

^0 

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M 

LABOR-SAVING  DEVICES  I93 

are  due  may  be  incorporated  in  the  form.  The  illustration  above 
is  worth  careful  study.  It  is  assumed  here  that  in  this  business 
the  goods  have  been  bought  with  the  understanding  that  the 
shipper  is  responsible  for  the  freight  charges  but  the  buyer  pays 
the  freight  bill.  This  means  that  when  the  buyer  pays  the  freight 
bill  he  is  in  effect  making  partial  payment  on  the  purchase,  and 
hence  he  debits  the  shipper  for  that  payment  as  if  the  money  had 
been  sent  to  the  shipper.  That  is  why  we  have  in  the  illustration 
several  small  or  partial  payments  charged.  Enough  space  must 
be  left  between  purchases  to  provide  for  the  debits.  Of  course,  in 
the  cash  book,  from  which  these  debit  postings  come,  the  controll- 
ing account  is  debited  to  match  these  debits. 

TABULAR  LEDGER 

Ledger  as  Book  of  Original  Entry.  If  a  business  sells  only  a 
few  kinds  of  commodities  or  renders  only  a  few  kinds  of  services 
but  to  many  customers,  it  would  be  a  pity  to  write  all  the  entries 
in  full,  all  virtually  alike,  and  then  make  himdreds  or  thousands 
of  postings.  When  much  variation  occurs  in  entries  no  short-cut 
beyond  the  point  to  which  we  have  already  gone  is  very  helpful, 
for  no  summary  can  be  made;  but  if  the  transactions  are  so  much 
alike  that  tabulation  is  possible  such  tabulation  may  sometimes 
take  the  place  of  entries  or  actually  constitute  the  entries.  Sup- 
pose an  electric-lighting  corporation  to  serve  current  for  Hght  and 
for  power  (at  a  different  rate),  and  to  sell  lamps  and  appliances. 
Virtually  every  customer  will  have  a  charge  every  month,  and 
though  a  customer  may  have  more  than  one  charge  in  a  month 
for  lamps  and  appliances,  those  charges  may  be  accumulated  and 
need  be  entered  only  at  the  end  of  the  month,  for  bills  are  payable 
monthly.  The  bookkeeper  needs  to  do  two  things :  debit  the  cus- 
tomers, and  credit  separate  accounts  for  the  four  kinds  of  earnings 
—  thus  distinguishing  for  statistical  purposes  income  from  light- 
ing current,  from  power  current,  from  lamps,  from  appliances. 
Under  normal  bookkeeping  methods  he  would  credit  the  income 
accounts  from  the  original  entries  as  totals  of  columns,  and  then 
debit  the  customers  by  posting  to  each  individually.  If,  however, 
we  can  so  arrange  our  customers  ledger  that  the  charges  to  the 
individual  customers  for  the  month  for  each  kind  of  service  can  be 


194 


THE  FUNDAMENTALS  OF  ACCOUNTING 


added  together  on  the  ledger  itself,  and  thus  give  our  total  credit 
to  each  of  the  earnings  accounts,  we  do  not  need  any  original 
entries  as  such,  but  can  post  directly  to  the  customers  ledger 
from  the  inspectors'  reports  of  meter  readings  and  the  store's 
charge  slips  of  lamps  and  appliances,  and  then  save  these  reports 
and  slips  for  reference.  This  can  be  done  if  we  rim  our  customers 
ledger  horizontally  rather  than  vertically.  In  the  ordinary  type 
of  ledger  charges  are  placed  under  each  other,  items  originating 
many  months  apart  coming  into  juxtaposition.  It  is  not  easy 
(indeed,  it  is  almost  impossible  without  error)  to  pick  out  the 
items  of  any  one  month  and  learn  the  charges  of  the  period. 
When,  however,  the  ledger  runs  horizontally,  and  charges  for  any 
month  are  in  a  column  for  that  month,  the  total  of  the  column  for 
that  month  is  the  total  charge  to  all  customers  for  that  month 
from  that  source.  If  several  columns  are  provided  for  each 
month,  the  incomes  from  separate  sources  may  be  learned  in  the 
same  way  and  from  the  totals  of  the  columns  of  the  customers 
ledger  may  be  posted  to  the  credit  of  the  various  income  accounts. 
This  is  shown  in  the  form  below.  In  addition,  since  balances  on 
customers'  accounts  cannot  now  be  brought  down,  they  are  car- 
ried over  in  a  special  column.  They  will  complicate  entries  to  the 
controlling  account  unless  precaution  is  taken,  but  this  is  easily 
provided  as  explained  in  a  note  to  the  form. 

Tabular  Ledger 


January 

February 

Bal- 
ance 

Light 

Power 

Lamps 

A  p. 
pliances 

Total 

Dis. 
count 

Cash 

Bal- 
ance 

Light 

Power 

Etc. 

Smith 
Brown 
Jones 

8.0O 

15.00 
5.00 

23.00 
50.00 

2. CO 

40.00 
13-00 
50.00 

2.30 
.50 

37-70 
12.50 

50.00 

8.00 

20.00 

73-00 

2.00 

© 

103.00 
8.00 

2.80 

© 

50.20 
2.80 

95.00 

© 

53-00 

© 

Accounts  Receivable 

95. CO 

To  Light 

20.00 

Power 

73.00 

Lamps 

2.00 

Appliances 

0.00 

LABOR-SAVING  DEVICES  I95 

The  debit  to  Accounts  Receivable  is  not  the  footing  of  the  column  for  total,  for  that 
includes  balances  brought  over;  so  the  total  of  the  balances  is  subtracted  and  the 
net  is  posted  to  the  controlling  account.  The  credit  to  Accounts  Receivable  will 
be  greater  than  the  cash-book  receipts  by  the  amount  of  the  discounts:  since  the 
discount  does  not  need  to  appear  on  the  cash  book,  the  credit  to  Accounts  Receiv- 
able may  be  made  from  this  tabular  ledger  after  the  discoimt  column  and  the  cash 
column  have  been  added  together.  The  total  of  the  cash  column,  however, 
should  be  checked  for  accuracy  with  the  total  of  the  special  column  in  the  cash  book. 
The  figures  below  the  totals  are  posting  checks  for  the  general  ledger.  The  net  effect 
of  these  entries  is 

Cash  50.20 

Discount  Given  2 .  80 

To  Accounts  Receivable  S3-oo 


VOUCHER-PAYABLE  SYSTEM 
A  Substitute  for  a  Ledger.  Not  many  years  ago  it  was  common 
for  business  houses  to  keep  a  "running  account"  with  their  credi- 
tors or  customers,  with  no  special  care  that  payments  should 
exactly  meet  particular  bills.  Purchases  might  be  scattered 
through  the  month,  and  payment  of  a  lump  sum  approximately 
sufficient  to  cover  the  items  would  be  made  in  the  following 
month  or  later,  with  the  intention  of  keeping  debits  and  credits 
virtually  parallel  but  not  necessarily  tallying  item  by  item.  This 
custom  made  it  necessary  to  keep  a  ledger  account  with  each 
creditor  and  each  debtor,  so  that  the  balance,  which  might  not  be 
the  exact  amount  of  any  bill  or  group  of  bills,  could  be  easily 
noted.  In  recent  years  this  method  has  seemed  too  easy-going. 
Business  men  wish  to  have  specific  bills  paid,  and  paid  on  specified 
due  dates.  It  is  obvious  that  under  this  plan  no  ledger  account 
with  each  creditor  is  essential,  for  a  file  or  list  of  unpaid  bills  gives 
the  desired  information  —  the  balance  owed  each  creditor  is  al- 
ways one  or  more  specific  unpaid  bills.  It  is  therefore  nowadays 
rather  common  to  find  such  a  list  of  unpaid  bills  —  systematically 
arranged,  of  course  —  substituted  for  the  old  accounts-payable 
ledger.  It  is  not  conomon  to  find  such  a  list  substituted  for  the 
accounts-receivable  ledger,  for  such  an  arrangement  is  not  con- 
venient when  the  number  of  items  is  large  —  and  accounts  re- 
ceivable are  usually  far  more  numerous  than  accounts  payable, 
for  sales  are  usually  made  in  smaller  units  than  purchases. 


196  THE  FUNDAMENTALS  OF  ACCOUNTING 

The  Principle.  The  method  of  substituting  a  list  of  accounts 
payable  for  the  subordinate  ledger,  when  it  is  coupled  with 
the  method  of  entry  described  below,  is  commonly  called  the 
"  voucher  system/'  The  term  is  flexible,  however,  and  may  com- 
prise more  or  less  than  what  is  described  here.  In  essence,  the 
voucher  system  consists  of  four  parts:  (i)  substituting  an  account 
called  "Vouchers  Payable"  for  the  old  Accounts  Payable;  (2) 
substituting  a  list  of  consecutively  numbered  bills  for  the  old 
subordinate-ledger  accounts;  (3)  providing  as  an  intrinsic  part  of 
the  arrangement  of  the  list  of  bills,  or  form  for  listing  them,  ade- 
quate means  for  making  postings  to  the  various  accounts  that  are 
to  be  debited,  and  to  Vouchers  Payable  which  is  to  be  credited; 
and  (4)  making  debits  to  Vouchers  Payable  from  the  cash  book 
whenever  bills  listed  are  paid.  This  saves  the  labor  of  posting 
credits  to  individual  accounts,  for  the  original  listing  of  the  bill  is 
itself  the  original  entry  and  posting  all  in  one.  The  listing  of  the 
bills  in  appropriate  columns  makes  possible,  by  mere  addition,  the 
determination  of  debits  to  the  various  accounts  for  which  the  bills 
were  incurred —  just  as  in  the  tabular  ledger  shown  above  we 
found  the  credits  to  the  earnings  accounts  from  the  total  of  the 
columns  of  charges  to  customers.  This  is  virtually  the  reverse  of 
the  particular  tabular  ledger  shown  above  except  for  one  thing: 
the  unit  of  entry  in  that  tabular  ledger  is  the  customer,  and  all 
his  items  appear  in  one  place  for  one  month  (for  he  is  a  regular 
customer  and  therefore  has  an  established  place) ;  but  the  unit 
of  entry  under  the  voucher  system  is  the  bill,  and  bills  are 
entered  in  chronological  order  irrespective  of  who  the  creditors 
may  be. 

The  Voucher  Register.  The  voucher  register  is  the  key  of  the 
system.  In  the  form  following,  the  columns  at  the  right  are  for 
the  debits  to  be  made  for  the  purchases  (or  liability  for  services, 
like  telephone  service,  etc.),  but  not  every  account  that  may  need 
a  debit  is  provided  with  a  column.  A  group  of  columns  is  pro- 
vided for  sundry  items  which  do  not  have  individual  columns, 
and  these  must  of  course  be  posted  individually  as  are  items  in  the 
sundries  column  of  a  cash  book.  In  order  to  indicate  to  what  ac- 
counts these  items  are  to  be  posted,  a  column  is  provided  (jour- 
nalization colimm),  and  of  course  a  ledger-foKo  column  is  needed 


LABOR-SAVING  DEVICES  I97 

for  the  posting  checks.  The  amount  of  all  bills  is  entered  in  the 
column  provided  for  the  amount  (in  the  middle  of  the  page),  and 
then  is  repeated  or  distributed  in  the  columns  indicating  the  ac- 
counts to  be  debited.  The  total  of  the  column  provided  for  the 
amount  is  credited  to  Vouchers  Payable  (the  liability  of  the  busi- 
ness to  make  payment).  This  takes  care  of  the  original  entries 
and  postings  for  debts  incurred.  When  debts  are  recorded  as 
paid  on  the  cash  book,  Vouchers  Payable  is  debited  from  that 
book  and  notation  is  needed  here  (since  here  is  the  only  record  of 
the  specific  debt)  that  the  debt  has  been  paid  (as  would  be  the 
case  if  we  had  a  ledger  account  for  each  firm  to  which  we  owed  the 
debts).  This  is  given  by  entering  in  the  columns  for  pa)nnent  the 
date  of  payment  and  the  number  of  the  check  by  which  payment 
was  made.  If  the  payment  is  not  recorded,  the  bill  is  not  paid. 
So  a  single  line  here  is  virtually  a  subordinate-ledger  account,  and 
the  sum  of  the  items  not  marked  paid  must  equal  the  balance  of 
Vouchers  Payable  in  the  general  ledger. 

Accessories.  Many  business  houses  like  uniform  bills  for  filing 
purposes,  and  hence  have  their  own  forms  which  they  request 
their  creditors  to  use  in  making  out  bills.  They  send  the  printed 
form  for  this  purpose,  and  that  fact  explains  the  "to  whom  is- 
sued" caption  for  the  second  column  of  the  voucher  register 
above.  Often  payment  is  made  by  so-called  "voucher  checks," 
which  differ  from  ordinary  checks  chiefly  in  having  upon  them  a 
duplicate  or  summary  of  the  bill  and  contain  evidence  of  the  pay- 
ment of  the  bill,  because  endorsement  of  the  check  is  so  arranged 
that  it  automatically  receipts  the  bill.  These,  however,  are  mat- 
ters not  of  bookkeeping  but  of  ofl&ce  and  financial  administration, 
and  are  mentioned  here  only  as  completing  the  statement  of  what 
is  sometimes  meant  by  the  "voucher  system." 

Comment  on  the  System.  This  is  a  very  convenient  method  of 
recording  small  or  occasional  debts  incurred  and  of  getting  them 
posted  with  the  minimtmi  labor  to  the  appropriate  purchase  or 
expense  accounts.  Its  obvious  inconvenience  is  that  the  transac- 
tions, past  and  present,  with  one  firm  are  not  all  in  one  place  for 
reference,  but  are  badly  scattered.  If,  moreover,  we  wish  to 
know  how  much  we  owe  any  firm,  we  may  have  to  look  back  over 
many  pages  to  see  how  many  bills  the  firm  has  against  us.    If  we 


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LABOR-SAVING  DEVICES  I99 

keep  bills  paid  promptly,  however,  this  will  not  be  laborious.  If, 
too,  we  keep  a  card  index  of  all  vouchers  payable,  arranged  alpha- 
betically by  creditors,  the  task  of;finding  the  record  of  our  rela- 
tions with  any  firm  is  not  great.  When  it  comes  to  this,  however, 
the  task  of  making  postings  to  a  subordinate  ledger  is  hardly 
greater;  for  debit  postings  must  be  made  from  the  cash  book  in 
any  case,  either  to  the  voucher  register,  as  just  shown,  or  to  the 
ledger,  and  it  is  virtually  as  much  work  to  enter  credit  items  in  an 
index  as  in  a  ledger.  In  summary,  the  voucher  system  is  excellent 
for  small  and  occasional  items  for  which  the  record  will  not  proba- 
bly need  indexing;  but  for  purchases  or  expenses  connected  with 
firms  for  whom  complete  records  of  dealings  are  important,  the 
regular  method  of  ledger  accounts  is  usually  more  satisfactory. 
Nothing  of  the  voucher  system  that  is  valuable,  however,  need  be 
given  up  even  if  the  ledger  accoimts  are  maintained;  for  the 
voucher  register  may  be  used  as  a  medimn  of  posting  to  ledger 
accounts  of  creditors  (merely  adding  a  column  for  accounts  paya- 
ble and  placing  in  that  column,  rather  than  in  that  for  vouchers 
payable,  items  to  be  posted  to  a  subordinate  ledger,  and  posting 
the  total  to  Accoimts  Payable),  and  the  uniform  voucher  form 
and  voucher  check  can  likewise  be  used  where  desired. 

PRIVATE  LEDGERS 
The  Principle.  A  labor-saving  device  is  sometimes  an  apparent 
contradiction  in  terms.  It  may  make  more  labor  than  it  saves, 
and  yet  be  in  a  sense  labor-saving.  If  it  saves  high-cost  labor 
and  substitutes  even  more  low-cost  labor,  it  may  be  worth  while. 
The  establishment  of  the  private-ledger  system  reduces  the  work 
otherwise  necessary  of  the  confidential  bookkeeper  —  who  is  often 
a  member  of  the  firm  and  a  person  whose  time  is  very  valuable. 
The  purpose  of  the  private  ledger  is  to  keep  in  the  confidential 
files,  inaccessible  to  general  bookkeepers,  certain  matters  that 
these  bookkeepers  do  not  need  to  know,  such  as  the  investment, 
the  amount  of  profits,  the  salaries  of  partners,  what  money  is  bor- 
rowed, and  what  real  estate  and  other  property  not  directly  con- 
nected with  operations  is  owned.  Transactions  involving  the 
sort  of  thing  just  mentioned  are  infrequent.  It  is  not  much  labor 
for  any  one  to  record  them.    The  complication  arises  from  the 


200  THE  FUNDAMENTALS  OF  ACCOUNTING 

fact  that  many  of  them  are  inextricably  tied  up  with  transactions 
which  require  great  labor  to  record.  Profits,  for  instance,  are  de- 
pendent on  purchases  and  sales;  but  no  busy  partner  or  confiden- 
tial bookkeeper  should  take  time  to  enter  sales:  they  must  be 
handled  by  others.  The  task,  then,  is  to  devise  a  plan  of  letting 
each  bookkeeper  keep  what  he  must  and  then  of  relating  the  two 
sets  of  items  without  letting  the  general  bookkeepers  know  what 
confidential  things  are  related  to  the  non-confidential  things. 
Since,  too,  the  confidential  bookkeeper  cannot  give  time  to  getting 
trial  balances,  etc.,  for  the  general  bookkeepers,  the  general  books 
must  be  complete  in  themselves,  must  stand  squarely  on  their 
own  feet.  This  suggests  that  two  sets  of  books  are  kept,  each 
complete  in  itself,  but  with  certain  matters  common  to  both  sets 
of  books.  The  best  way  to  see  that  this  is  possible  is  to  remember 
that  our  Accounts  Receivable  are  in  part  somebody's  else  Ac- 
counts Payable,  for  what  I  am  owed  somebody  owes  me,  and  the 
item  is  on  both  sets  of  books  without  confusion  of  other  items  on 
either.  That  is  virtually  the  relation  of  private  and  general 
ledgers.  The  inside  (confidential)  office  is  treated  as  if  it  were  a 
separate  business  that  had  dealings  with  the  outside  (general) 
office,  and  vice  versa.    Let  us  now  examine  the  method. 

Starting  the  System.  Supposing  the  system  is  begun  after  the 
common  system  is  already  in  operation,  the  first  step  is  to  estab- 
lish in  the  new  private  books  the  present  status  of  the  accounts 
which  hereafter  are  to  be  kept  exclusively  in  the  private  books. 
Since,  too,  the  private  ledger  should  be  the  ultimate  receptacle  of 
all  the  facts  about  the  business,  so  that  a  bird's-eye  view  of  the 
business  may  be  taken  by  the  partners  from  it  without  consulting 
the  general  or  outside-office  ledger,  a  summary  should  be  made  in 
the  private  ledger  of  the  status  of  all  accounts  to  be  kept  hereafter 
in  the  general  ledger.  In  other  words,  we  will  transfer  to  the 
private  ledger  a  large  number  of  accounts  from  the  general  ledger, 
and  we  will  enter  in  the  private  ledger  not  only  the  accounts  taken 
over  from  the  general  ledger  but  a  summary  of  the  accounts  re- 
maining on  the  general  ledger.  Let  us  illustrate  by  a  concrete 
case.  Following  is  the  balance  sheet  of  a  business  on  the  day 
when  the  new  system  is  to  be  inaugurated: 


LABOR-SAVING  DEVICES  20I 


Cash 

$  5,000 

Partner  A 

$40,000 

Accounts  Receivable 

20,000 

Partner  B 

50,000 

Merchandise  Inventory- 

17,000 

Accounts  Payable 

16,000 

Fixtures 

8,000 

Notes  Payable 

4,000 

Real  Estate 

60,000 
$110,000 

$110,000 

It  is  now  intended  to  have  the  general  bookkeepers  take  care  of  all 
entries  relating  to  purchases,  to  sales,  and  to  current  running  ex- 
penses, and  to  have  them  handle  the  cash  account,  but  to  have 
them  know  nothing  else  about  the  business  except  what  they  al- 
ready know.  Even  expenses  like  interest,  taxes,  etc.,  which  occur 
only  occasionally  and  therefore  do  not  make  too  much  labor  of 
entry  for  the  confidential  bookkeeper,  they  are  not  to  know.  The 
first  step  is  to  transfer  to  the  private  ledger  all  items  on  the  bal- 
ance sheet  except  Cash,  Accounts  Receivable,  and  Accounts  Pay- 
able. To  get  these  items  on  the  private  ledger  we  must  on  that 
ledger  debit  Merchandise,  Fixtures,  and  Real  Estate,  and  must 
credit  the  partners  and  Notes  Payable;  but  as  we  wish  this  ledger 
to  be  in  balance,  we  must  debit  or  credit  something  for  the  dif- 
ference between  the  two  sides.  It  is  actually  $9,000  [40,000  -f 
50,000  -h  4,000 -(17,000  -h  8,000  +  60,000)].  What  is  the  real 
meaning  of  this  difference?  We  have  taken  over  to  the  private 
ledger  more  liabilities  of  the  business  (including  partners'  bal- 
ances) than  assets,  by  $9,000.  Why?  Because  we  have  not 
taken  over  a  part  of  the  assets  available  for  meeting  the  liabilities 
taken  over.  Where  are  those  assets?  On  the  general  ledger. 
Then  we  will  debit  the  general  ledger  as  responsible  for  these  as- 
sets: we  will  open  an  accoimt  in  the  private  ledger  and  will  call  it 
"General  Ledger."  So  our  first  entry  on  the  private  journal,  to 
be  posted  to  the  private  ledger,  is 


Merchandise  Inventory 

17,000 

Fixtures 

8,000 

Real  Estate 

60,000 

General  Ledger 

9,000 

To  Partner  A 

40,000 

Partner  B 

50,000 

Notes  Payable 

4,000 

It  is  now  to  be  noted  that  this  $9,000  is  not  only  the  excess  of 
credits  taken  by  the  private  ledger  over  the  debits  taken  by  it,  but 


202  THE  FUNDAMENTALS  OF  ACCOUNTING 

is  actually  the  value  of  the  assets  continued  on  the  general  ledger 
over  the  liabilities  so  shown;  for  the  assets  still  on  the  general 
ledger  are  $25,000  (5,000  +  20,000)  and  the  liabilities  are  $16,000. 
We  must  now  obviously  bring  our  general  ledger  into  accord  with 
the  new  plan,  taking  off  from  it  the  items  transferred  to  the  pri- 
vate ledger,  and  crediting  the  private  ledger  for  the  excess  liabili- 
ties (to  partners)  which  it  has  taken  over  from  the  general  ledger. 
The  entry  follows: 


Partner  A                                         40,000 
Partner  B                                          50,000 
Notes  Payable                                   4,000 
To  Merchandise  Inventory                           17,000 
Fixtures                                                       8,000 
Real  Estate                                              60,000 
Private  Ledger                                         9,000 

V  let  us  observe  the  balance  sheet  of  each  ledger. 

Private  Ledger 

Merchandise 
Fixtures 
Real  Estate 
General  Ledger 

$17,000            Partner  A 
8,000            Partner  B 
60,000           Notes  Payable 
9,000 
$94,000 

$40,000 

50,000 

4,000 

$94,000 

General  Ledger 

Cash 

Accounts  Receivable 

$  5,000           Accounts  Payable 
20,000            Private  Ledger 

$16,000 
9,000 

$25,000 

$25,000 

Why  does  the  private  ledger  have  a  debit  of  $9,000' to  the  general 
ledger?  Because  the  latter  is  responsible  to  account  for  a  net 
$9,000  of  property.  Why  does  the  general  ledger  have  a  credit  of 
$9,000  to  the  private  ledger?  Because  the  inside  ofl&ce,  repre- 
sented by  the  private  ledger,  has  left  in  the  care  of  the  outside 
office  $9,000  of  excess  of  assets  (over  liabilities)  to  be  accounted 
for;  and  the  inside  office  now  keeps  ultimate  control  of  all 
accounts  in  its  own  hands,  for  it  has  a  controlling  account 
which  controls  even  the  controlling  accounts  kept  by  the  out- 
side office. 
Operating  the  System.    The  most  convenient  way  to  operate 


LABOR-SAVING  DEVICES  203 

the  system  is  to  have  two  cash  accounts,  and  two  bank  accounts, 
one  to  be  handled  in  each  office;  but  for  the  sake  of  studying  the 
method  under  the  most  adverse  circumstances,  we  will  assume 
here  only  one  cash  account  and  only  one  bank  account.  Obvi- 
ously ordinary  transactions  of  purchase,  sale,  and  expense,  will  be 
handled  now  in  the  usual  way,  entered  on  the  general  books  only. 
The  accounts  on  the  private  books  are  not  affected  by  these  trans- 
actions and  hence  get  no  entries  currently.  Now  suppose  $5,000 
is  borrowed  on  notes  payable.  The  general  bookkeepers  are  not 
to  know  where  the  money  came  from.  They  are  merely  told  to 
credit  the  private  ledger,  and  the  cash  is  deposited  in  the  regular 
bank  account  by  the  confidential  bookkeeper.  So  the  general 
bookkeepers  debit  Cash  and  credit  Private  Ledger,  and  the  confi- 
dential bookkeeper  debits  General  Ledger  and  credits  Notes  Pay- 
able. If,  now,  the  old  notes  payable  are  paid,  the  confidential 
bookkeeper  gets  a  blank  check  from  the  general  bookkeeper,  tells 
him  the  amoimt  to  be  drawn  on  the  check  and  instructs  him  to 
debit  Private  Ledger,  and  then  he  himself  debits  Notes  Payable 
and  credits  General  Ledger.  At  the  end  of  the  month  the  can- 
celled checks  are  secured  from  the  bank  by  the  confidential  book- 
keeper, who  removes  the  checks  chargeable  on  the  private  ledger, 
and  then  gives  the  rest  of  them  to  the  general  bookkeeper,  notify- 
ing him  also,  of  course,  of  any  such  checks  still  outstanding.  In 
this  way  each  set  of  books  goes  its  own  way,  but  joint  transactions 
are  entered  on  both,  in  reversed  entries,  and  each  with  such  detail 
only  as  each  needs.  Entries  which  do  not  concern  the  general 
bookkeepers,  because  not  touching  accoimts  that  they  keep,  are 
entered  in  the  private  books  only. 

Finding  Profit.  In  finding  profits  we  have  to  establish  a  new 
relation.  The  general  bookkeepers  preferably  should  not  know 
inventories,  for  if  they  do,  knowing  purchases  and  sales,  they  will 
know  gross  profits,  and  knowing  also  most  of  the  expenses  they 
will  know  often  too  much  about  net  profits  —  and  in  these  days 
of  floating  office  help  it  is  well  not  to  leave  lying  around  loose  in- 
formation that  a  floating  bookkeeper  may  carry  some  day  to  a 
competing  firm.  With  inventories  on  the  private  ledger  only, 
and  purchases,  sales,  and  current  expenses  on  the  general  ledger 
only,  the  task  is  simply  to  transfer  to  the  private  ledger  all  in- 


204  THE  FUNDAMENTALS  OF  ACCOUNTING 

formation  needed  there  for  finding  profit.  Suppose  during  the 
current  period  there  have  been  entered  on  the  general  ledger  pur- 
chases of  $168,000,  sales  of  $219,000,  and  expenses  of  $36,000, 
and  that  the  inventory  of  merchandise  at  the  end  of  the  year  is 
$28,000.    On  the  general  books  these  entries  would  be  made: 

Sales  219,000 

To  Private  Ledger  219,000 

Private  Ledger  204,000 

To  Purchases  168,000 

Expenses  36,000 

This  closes  the  three  nominal  accounts  named,  and,  for  the  net 
credit  of  the  three  of  them  as  previously  standing  on  the  general 
ledger,  substitutes  a  net  credit  to  Private  Ledger.  On  the  private 
books  this  entry  would  be  made  (or  two  entries,  the  reverse  of 
the  two  above,  would  be  used) : 

Purchases  168,000 
Expenses  36,000 

General  Ledger  15,000 

To  Sales  219,000 

Why  in  this  last  entry  is  the  general  ledger  debited  $1 5,000?  Be- 
cause during  the  period  of  operations  the  business  has  acquired 
assets,  as  a  result  of  bu3dng  and  selling,  of  $15,000,  which  are  still 
on  the  books  of  the  outside  office  and  have  never  been  put  on  the 
books  of  the  inside  office,  but  should  now  appear  on  those  books 
as  a  charge  to  the  outside  office  (for  the  outside  office  still  holds 
the  property,  or  has  already  been  credited  if  it  has  surrendered 
any).  Similarly  in  the  entry  on  the  general  books,  the  inside 
office  is  now  taking  over  the  accounts  for  the  profits  made  (as  far 
as  they  are  covered  by  the  items  above),  but  allows  the  outside 
office  to  retain  the  accounts  for  the  assets;  and  so  the  inside  office 
Is  credited  for  the  increase  of  assets  which  it  allows  the  outside 
office  to  keep  even  though  it  takes  over  the  earnings  accounts. 
Now  profits  can  be  found  on  the  private  ledger,  for  when  the  new 
inventory  is  entered  all  the  elements  of  profit  will  be  there.  Sup- 
posing for  simplicity  that  no  expenses  had  been  incurred  except 
those  on  the  general  ledger,  we  should  then  have  these  closing 
entries  for  finding  profits  (using,  for  illustration,  the  simplest 
method  of  closing) : 


LABOR-SAVING  DEVICES 

Loss  and  Gain 
To  Merchandise  Inv.  [old] 
Purchases 

221,000 

17,000 
168,000 

Expenses 

36,000 

Sales 

Merchandise  Inventory  [new] 
To  Loss  and  Gain 

219,000 
28,000 

247,000 

205 


The  Balance  Sheet.  In  order  to  draw  up  our  balance  sheet,  we 
must  talie  items  from  each  ledger.  Let  us  suppose,  for  the  sake 
of  simplicity,  that  all  the  profits  except  those  that  are  now  in  the 
form  of  increased  inventory  are  in  the  form  of  cash,  that  our  col- 
lections and  payments  on  bills  have  left  our  accounts  receivable 
and  accounts  payable  just  as  they  were  at  the  beginning  of  the 
period,  that  the  $5,000  which  we  borrowed  on  notes  over  the 
$4,000  that  we  paid  on  notes  is  still  in  the  form  of  cash,  and  that 
our  fixtures  and  real  estate  have  not  depreciated.  Then  the  trial 
balances  of  the  two  ledgers  will  be  as  follows: 

General  Ledger 
Cash  $21,000 

Accounts  Receivable  20,000 


Accounts  Payable 
Private  Ledger 

$16,000 
25,000 

$41,000 

$41,000 

Private  Ledger 

Merchandise  Inventory 
Fixtures 

$28,000 
8,000 

Real  Estate 

60,000 

General  Ledger 
Partner  A 

25,000 

$40,000 

Partner  B 

50,000 

Notes  Payable 
Loss  and  Gain 

5,000 
26,000 

$121,000 

$121,000 

Why  should  the  general  ledger  stand  debited  for  $25,000  on  the 
private  ledger?  Because  it  has  accountability  for  $21,000  of  cash 
and  $4,000  of  excess  of  accounts  receivable  over  accoimts  paya- 
ble. Similarly,  the  general  ledger  shows  credit  to  the  private 
ledger  for  this  $25,000  of  net  assets  which  it  is  allowed  to  keep. 
Then  the  balance  sheet  of  the  business  as  a  whole  will  simply 


206  THE  FUNDAMENTALS  OF  ACCOUNTING 

combine  the  two  trial  balances  into  one  after  cancelling  the  pri- 
vate-ledger account  on  the  general-ledger  trial  balance  against 
the  general-ledger  account  on  the  private-ledger  trial  balance,  as 
follows: 


Cash                                  $21,000 

Partner  A 

$40,000 

Accounts  Receivable            20,000 

Partner  B 

50,000 

Merchandise  Inventory        28,000 

Accounts  Payable 

16,000 

Fixtures                                  8,000 

Notes  Payable 

5,000 

Real  Estate                         60,000 

Loss  and  Gain 

26,000 

$137,000 

$137,000 

QUESTIONS  AND  PROBLEMS 

Discounts 

1.  The  Brown  Manufacturing  Company  sells  goods  on  the  following 
terms:  spot  cash,  10%  off;  10  ds.,  5%;  30  ds.,  2%;  60  ds.,  net.  It  col- 
lects from  Green  &  Son  payment  on  their  bill  for  $1,000  that  has  run 
30  days,  from  White  Brothers  payment  on  a  bill  for  $2,000  shipped 
to-day,  from  Black  payment  on  a  bill  for  $500  that  has  run  one  week, 
and  from  Lavender  payment  on  a  bill  for  $1,250  that  has  run  65  days. 

Show  by  three  methods  the  entries  in  the  cash  book  for  the  receipt  of 
cash,  and  indicate  the  postings  that  are  to  be  made  from  the  cash  book, 
not  attempting  to  show  discounts  forfeited  by  customers. 

How  different  under  each  method  would  the  debit  side  of  the  cash 
book  look  if  discounts  of  $100  had  been  taken  by  the  business  during 
the  same  period? 

2.  Goods  are  both  bought  and  sold  on  the  following  terms:  8%  in  10  days, 
4%  in  30  days,  60  days  net.  Enter  in  the  cash  book  the  following  trans- 
actions subject  to  these  discounts,  and  show  what  postings  would  be 
made  from  it,  not  showing  discounts  forfeited,  when  you 

(a)  have  a  column  for  discounts  to  be  carried  contra,  and  use 
totals  in  the  column  for  the  controlling  account,  and 

(b)  carry  no  discounts  contra,  and  use  net  cash  in  the  column  for 
the  controlling  accounts. 

On  January  i,  Jones  pays  his  invoice  of  Nov.  2,  amounting  to  $700; 
Smith  pays  his  invoice  of  Dec.  2,  amounting  to  $2,000;  Brown  pays  his 
invoice  of  Dec.  22,  amounting  to  $500. 

We  also  on  that  day  pay  to  Blucher  a  bill  of  Dec.  3,  $750,  and  to 
Oxford  a  bill  of  Dec.  23,  $800. 

3.  Devise  a  form  of  cash  book  for  showing,  when  bills  are  paid  by  the 
firm,  what  discounts  it  takes,  what  discounts  it  forfeits,  and  what  should 
be  credited  to  Merchandise  for  correction  of  the  original  over-debit  to 
Merchandise  at  the  time  the  bills  were  received  —  the  portion  of  the 
bill  which  was  for  assumed  delay  in  payment,  as  discussed  on  pages  122- 
123.    In  this  form  do  not  carry  discounts  "  contra  " ;  and  use  net  cash  in 


LABOR-SAVING  DEVICES  ^0^ 

the  column  for  the  controlling  account.    Apply  to  the  form  which  you 
devise  the  two  entries  in  the  last  paragraph  of  Problem  2  above. 

Tabular  Ledger 

4.  (a)  Construct  a  tabular  ledger  to  show  for  the  individual  depositors  of 

a  bank  their  daily  balances,  daily  deposits,  and  daily  checks  drawn. 
Enter  in  the  tabular  ledger  the  following: 

At  the  close  of  business  on  Wednesday,  May  22,  the  balance  of 
A.  Oakes  is  $140,  of  James  Robinson  $1,213,  and  of  Silas  Lowell 
$219.10. 

On  Thursday,  May  23,  checks  of  the  following  were  presented  for 
payment:  Robinson,  $217,  $100,  $763;  Lowell,  $57.80.  On  that  day 
Oakes  deposited  $200. 

On  Friday,  May  24,  checks  were  presented  for  payment  as  fol- 
lows: of  Oakes,  $115,  $25;  of  Robinson,  $150,  $225,  $540.82;  of 
Lowell,  $400.  Deposits  were  made  by  Robinson  $2,016.20;  by 
Lowell  $238.11. 
(b)  Show  how  postings  for  deposits  and  checks  will  get  into  the  general 
ledger. 

The  Voucher  System 

5.  Show  on  the  voucher  register  and  on  the  cash  book  all  that  should  show 
for  the  following  transactions,  and  show  by  posting  checks  what  should 
be  posted  from  each  of  these  books. 

Jan.  I.  Mdse.  is  purchased  as  follows:  from  S.  &  Co.  $500,  payable 
in  10  ds.;  from  R.  &  R.  $750,  payable  in  10  ds.;  from  B.  &  M.  $1,000, 
payable  in  one  week.  Office  supplies  are  purchased  from  D.  &  Son 
for  $50,  payable  in  15  ds. 

Jan.  8.    B.  &  M.  are  paid  in  full. 

Jan.  II.    R.  &  R.  are  paid  in  full. 

Jan.  16.    D.  &  Son  are  paid  in  full. 

6.  How  will  you  record  on  the  Voucher  Register  the  payment  of  a  bill 
in  part? 

Private  Ledgers 

7.  Desiring  during  the  year  to  change  your  accounting  methods  so  that 
the  general  bookkeeper  cannot  learn  the  larger  and  more  confidential 
facts  of  the  business,  you  establish  a  private  ledger  into  which  are  to  be 
taken  all  items  of  the  general  ledger  except  Purchases,  Sales,  Accounts 
Receivable,  Accounts  Payable,  Expenses,  and  Cash. 

The  general-ledger  trial  balance  at  the  date  set  for  inaugurating  the 
new  system  is  as  follows: 


Cash- 

20,000 

Sales- 

160,000 

Purchases- 

150,000 

Accts.  Payable 

35,000 

Accts.  Receivable 

7S,ooo 

Notes  Payable 

33,000 

Expenses 

19,000 

Proprietor 

40,000 

Equipment 

4,000 
268,000 

368,000 

208  THE  FUNDAMENTALS  OF  ACCOUNTING 

(a)  Show  the  entries  on  both  the  general  journal  and  the  private 
journal  for  making  the  transfer,  and  show  the  skeleton  ledgers 
as  they  look  after  the  transfer. 

(b)  The  business  for  the  rest  of  the  year  is  as  follows: 

Sales  (all  on  charge  accounts),  $100,000;  purchases  (all  on 
charge  accounts),  $90,000;  collected  on  accounts  receivable, 
$110,000;  paid  on  accounts  payable,  $120,000;  paid  on  notes 
payable,  $20,000;  withdrawal  by  proprietor,  $10,000;  expenses 
paid,  $30,000;  borrowed  on  notes  payable,  $65,000. 

Supposing  only  one  cash  account,  handled  by  the  general  cash- 
ier, show  (in  journal  form)  the  entries  on  both  sets  of  books. 

(c)  Suppose  the  inventory  of  merchandise  at  the  end  of  the  year 
to  be  $40,000.  Show  the  method  of  finding  profits  and  closing 
them  to  the  proprietor's  account. 

(d)  Show  the  trial  balance  of  each  ledger  after  the  books  are  ad- 
justed for  the  balance  sheet. 

8.  The  trial  balance  of  the  general  ledger  of  a  business  on  December  31 
is  as  follows: 


Real  Estate 

3S,ooo 

Merchandise 

20,000 

Accounts  Receivable 

60,000 

Accounts  Payable 

25,000 

Notes  Payable 

15,000 

Fixtures,  etc. 

10,000 

Partner  A 

60,000 

Partner  B 

40,000 

Commission 

7,000 

Operating  Expenses 

48,000 

Cash 

14,000 
167,000 

167,000 

It  is  now  decided  to  open  a  private  journal  and  private  ledger,  and 
to  continue  on  the  old  books  only  items  needed  for  the  general  office. 
The  inventory  of  merchandise  is  foimd  to  be  $40,000,  the  real  estate 
must  be  depreciated  $3,000,  and  the  partners  draw  $5,000  cash  each: 
the  balance  of  profit  is  to  be  credited  to  partners  equally.  Show  the 
entries  for  closing  the  old  books  so  as  to  show  on  them  and  leave  on 
them  only  the  necessary  information,  and  show  the  entries  for  the 
private  journal  including  the  finding  of  profit  at  the  end  of  the  year. 

Show  the  final  trial  balance  of  each  ledger  after  adjustment,  and 
show  the generalbalance sheet. 


CHAPTER  XIV 

THE  TECHNIQUE  OF  CLOSING  THE  BOOKS 

The  Purpose  of  Closing  the  Books.  The  process  of  what  is  com- 
monly called  *' closing  the  books"  is  two-fold,  as  has  been  aheady 
suggested:  bringing  the  books  up  to  the  time,  and  providing  that 
the  balances  on  all  accounts  shall  be  those  properly  belonging  to 
the  new  period  which  is  about  to  begin,  thus  "closing''  the  active 
standing  of  the  now  obsolete  figures.  It  is  true,  of  course,  that 
though  these  are  distinct  purposes,  the  method  of  accomplishing 
them  is  virtually  the  same,  for  we  have  seen  that  when  the  books 
are  brought  to  the  time  dead  or  cancelled  balances  are  wiped  out 
and  new  live  balances  are  brought  in.  One  is  done  for  the  sake 
of  the  past  and  the  present,  the  other  for  the  sake  of  the  future; 
but  if  the  records  of  the  past  are  correct,  they  automatically  con- 
stitute the  records  with  which  the  future  must  begin. 

The  Varying  Task  of  Closing.  We  have  seen  a  large  variety  of 
methods  of  keeping  records,  not  only  with  respect  to  the  mechani- 
cal processes  of  making  original  entries  and  posting,  and  to  the 
content  of  various  accounts,  but  with  respect  to  the  extent  to 
which  the  accounts  are  kept  currently  up  to  the  time.  In  Chap- 
ter VIII  we  saw  accounts  that  enabled  us  to  show  virtually  every 
aspect  of  every  element  of  a  business  at  any  moment,  as  with  In- 
terest Accrued,  Interest  Prepaid,  Interest  Earned,  Interest  Ac- 
crued Liability,  Interest  Unearned,  and  Interest  Charges.  Yet 
we  saw  that  normally  these  accounts  are  not  kept  currently.  In- 
deed in  many  counting  houses  only  one  account  is  kept  for  inter- 
est. As  typical  of  a  short-cut  method  of  bookkeeping,  the  oppo- 
site extreme  of  the  six  accounts  just  mentioned,  it  will  now  pay  to 
examine  the  handling  of  interest  in  a  single  account. 

A  Single  Account  for  Interest.  It  is  obvious  that  if  a  single  ac- 
count for  interest  is  to  take  the  place  of  the  six  accoimts  already 
discussed,  four  of  which  were  real  and  two  nominal,  it  will  be  a 
mixed  account,  needing  adjustment  at  the  end  of  the  period,  for 
some  of  what  it  represents  will  have  been  converted  and  some  will 
remain  unchanged.    It  is  nexc  clear  that  the  debits  and  credits  of 


2IO 


THE  FUNDAMENTALS  OF  ACCOUNTING 


this  single  account  must  be  identical  with  the  debits  and  credits  of 
each  of  the  six  accounts  for  which  it  is  a  substitute,  or  else  con- 
solidating six  into  one  would  hide  information.  In  substance, 
then,  our  rule  for  the  single  account  becomes  this:  whenever  any 
of  the  six  accounts  previously  mentioned  would  be  debited,  debit 
the  single  account.  Interest;  when  any  of  them  would  be  credited, 
credit  Interest;  except,  of  course,  that  it  is  ridiculous  both  to  debit 
and  to  credit  Interest,  and  hence  when  any  entry  involves  two  of 
our  six  interest  accounts  we  omit  all  entry  —  unless  other  ac- 
counts also  are  concerned  and  more  is  involved  on  one  side  of  the 
six  than  on  the  other,  in  which  case  the  net  excess  only  is  entered 
to  Interest.  The  net  effect  of  all  this  is  that  a  debit  to  Interest 
may  mean  any  one  of  six  things  —  an  asset  in  the  form  of  interest 
accrued,  an  asset  in  the  form  of  interest  prepaid,  the  correction  of 
an  earning  overstated,  a  payment  of  interest  accrued  Hability, 
the  expiration  of  the  term  of  a  loan  for  which  interest  has  been 
collected  in  advance,  and  a  charge  (cost,  or  expense)  for  the  use  of 
money;  and  a  credit  to  interest  may  mean  any  one  of  six  things — 
payment  to  us  of  interest  accrued,  the  expiration  of  the  time  for 
which  we  have  prepaid  interest,  the  earning  of  interest  by  us,  in- 
curring liability  for  interest  to  be  paid  by  us,  receiving  interest  in 
advance  of  the  period  for  which  we  have  rendered  the  service  of 
loan,  and  a  correction  of  interest  charges  (cost,  or  expense).  Al- 
though here  is  much  consolidation  of  unlike  things,  the  account 
comes  out  exactly  right  in  the  end  if  at  the  time  of  adjustment  all 
items  of  accrual  and  prepayment  (both  in  favor  of  the  business 
and  against  it)  are  taken  into  consideration  by  any  one  of  the 
methods  about  to  be  described.  This  is  illustrated  by  the  four 
transactions  that  we  used  to  summarize  the  treatment  of  interest 
imder  the  six-account  method  shown  on  page  129.  For  conven- 
ience, the  table  of  transactions  is  repeated  here. 


DaUof 
transac- 
tion 

Kind  of  trans- 
action 

What  given 

Amount 
given 

What  got 

Amount 
got 

Note 
bearing 
interest 

Dec    I 

II 
16 
19 

borrowing 
lending 
lending 
borrowing 

Note  Payable 

Cash 

Cash 

Note  Payable 

$1000 

1200 
2000 

00 
50 
00 
00 

Cash 

Note  Rec. 
Note  Rec. 
Cash 

$  975 

600 

1200 

2000 

00 
00 
00 
00 

No 
No 
Yes 
Yes 

THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  211 

Under  the  single  account  for  interest  the  following  entries  would 
be  made  on  the  day  of  the  original  transaction  as  indicated. 

Dec.    I  Cash  975  oo 

Interest  [prepaid!  2  5 .  oo 

To  Notes  Payable  1000. 00 

Dec.  II  Notes  Receivable  600.00 

To  Cash  597.50 

Interest  [unearned]  2.50 

Dec.  16  Notes  Receivable  1200.00 

To  Cash  1200.00 

Dec.  19  Cash  2000,00 

To  Notes  Payable  2000.00 

The  debit  to  Interest  on  December  i  represents  an  asset:  we  have 
bought  and  paid  for  the  right  to  use  the  loan  for  a  certain  time. 
The  credit  to  Interest  on  December  11  represents  a  liability;  we 
have  taken  the  interest  payment  for  a  service  that  we  have  not 
yet  rendered,  and  we  are  liable  for  either  the  service  or  the  return 
of  a  portion  of  the  payment  in  case  the  note  is  paid  before  it  is  due. 
On  December  31  the  situation  has  changed  with  respect  to  all  four 
notes.  On  the  first  of  them,  the  asset  has  shrunk  by  30  days' 
expiration  (or  $5.00)  to  $20.00,  so  that  if  we  were  to  make  an 
entry  it  would  be  Interest  [charges],  Dr.,  Interest  [prepaid],  Cr.; 
on  the  second,  our  liability  has  shrunk  by  20  days'  service  ren- 
dered (or  $2.00)  to  $.50,  so  that  if  we  were  to  make  an  entry  it 
would  be  Interest  [unearned],  Dr.,  Interest  [earned],  Cr.;  on  the 
third,  15  days'  accrual  of  asset  in  our  favor  has  occurred,  $3.00,  so 
that  the  entry  would  be  Interest  [accrued].  Dr.,  Interest  [earned], 
Cr. ;  and  on  the  fourth  a  new  liability  has  been  incurred  for  interest 
to  be  paid,  12  days,  $4.00,  so  that  the  entry  would  be  Interest 
[charges].  Dr.,  Interest  [accrued  liability],  Cr.  We  do  not  make 
these  entries,  of  course,  for  they  would  produce  no  effect  on  the 
single  account  for  interest.  Under  the  single-account  method 
we  adjust  for  the  facts  of  asset  and  liability,  and  then  earnings 
and  charges  automatically  appear.  Though  Interest  is  on  our 
books  with  a  net  debit  balance  of  $22.50  ($25.00  debit  less  $2.50 
credit),  what  it  really  to-day  represents  in  the  way  of  real  things  is 
assets  of  $18.50  (assets  of  $20.00  and  $3.00,  less  liabilities  of  $.50 


212  THE  FUNDAMENTALS  OF  ACCOUNTING 

and  $4.00) ;  in  other  words,  a  conversion  has  taken  place,  so  that 
what  is  on  the  books  at  $22.50  is  a  net  asset  of  only  $18.50,  and 
$4.00  of  the  $22.50  must  be  transferred  from  this  interest  accomit 
to  Converted  Assets,  or  other  clearing  account,  and  only  $18.50 
will  be  carried  down  to  the  balance  sheet  and  the  new  year. 
This,  it  will  be  observed,  is  just  what  we  obtained  imder  the  six- 
accoimtmethod  discussed  in  Chapter  Vni  (page  130).  That  method 
gives  full  information  as  currently  as  we  wish  to  keep  it.  This 
method  gives  us  virtually  no  information  except  at  such  times  as 
we  are  willing  to  go  through  our  notes  and  drafts  and  see  what 
assets  or  liabilities  on  accoimt  of  interest  they  involve,  and  even 
then  the  information  for  the  balance  sheet  is  of  most  summary 
character,  whereas  the  other  method  gives  details. 

What  is  to  be  Closed.  With  such  variations  of  method  —  not 
to  be  regretted,  because  flexibility  is  the  soul  as  distinguished 
from  the  body  of  bookkeeping  —  it  is  clear  that  no  rule  of  thumb 
for  closing  the  books  can  be  followed.  So  far  as  an  account  is  al- 
ready written  up  to  the  time  —  that  is,  adjusted  to  the  time  of  the 
balance  sheet  —  nothing  remains  to  do  but  carry  down  to  the 
new  year  or  close  to  appropriate  clearing  accounts  the  balance 
shown  on  the  account.  The  title  of  an  account,  however,  will  not 
indicate  at  all  whether  it  is  adjusted  to  the  time  of  the  balance 
sheet  (unless,  indeed,  as  occasionally,  the  title  itself  includes  a 
date,  as,  Inventory  of  Merchandise,  January  i,  1922).  The  title 
may  suggest  current  adjustment,  as  Commission  Accrued,  In- 
surance Prepaid;  but  if  the  last  entries  are  old,  the  accoimt  needs 
adjustment  —  for  even  accounts  with  titles  that  suggest  current 
freshness  cannot  be  kept  absolutely  fresh  without  constant  and 
unnecessary  petty  adjustment  to  changes  of  no  daily  significance 
though  of  large  significance  over  longer  periods.  Every  account 
needs  examination  to  determine  whether  it  needs  adjustment. 
The  more  nearly  it  has  been  kept  fresh  currently,  the  less  adjust- 
ment it  will  need. 

The  Effect  to  be  Produced.  The  effect  to  be  produced  depends 
upon  the  degree  to  which  it  is  desired  that  the  balance  sheet  shall 
show  details.  This  may  again  be  illustrated  by  reverting  to  our 
six-account  and  one-account  method  of  handHng  interest.  Under 
the  six-account  method  we  have  on  our  balance  sheet  two  assets, 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  21 3 

Interest  Accrued,  and  Interest  Prepaid,  and  two  liabilities.  Inter- 
est Accrued  Liability,  and  Interest  Unearned.  Under  the  one- 
account  method  we  have  one  item  only.  Interest.  Do  we  wish 
our  balance  sheet  to  show  four  separate  items  for  interest,  or  one? 
The  discussion  following  will  indicate  the  principles  applicable 
to  closing,  but  will  not  attempt  to  carry  each  method  to  all  its 
applications ;  it  will  be  easy  to  see,  however,  how  any  account  de- 
scribed in  Chapter  VIII  can  be  provided  for  by  bookkeeping 
methods  if  only  the  necessary  information  has  been  preserved. 

Fundamental  Methods.  Three  fundamental  methods  of  clos- 
ing, and  variations  or  combinations  of  them,  are  in  use.  Choice 
between  them  is  less  a  matter  of  principle  than  of  taste  or  adapta- 
tion to  circumstances.  The  first  was  illustrated  in  Chapter  VII, 
in  which  we  by  journal  entries  took  out  of  certain  accounts  the 
values  still  shown  in  the  accounts  but  actually  not  in  the  business 
recognizable  imder  the  titles  of  the  accounts,  because  already 
converted  into  something  else,  and  left  in  the  original  accounts 
only  the  value  stiU  in  the  business  recognizable  under  the  names 
of  the  accounts.  The  second  may  be  said  to  be  virtually  the  re- 
verse of  this,  for  under  it  we  by  journal  entries  transfer  to  new 
accounts  any  inventories  which  remain  in  the  old  accounts,  so 
as  to  leave  the  old  accounts  (which  originally  represented  assets) 
purely  nominal  and  therefore  finally  representing  values  which 
are  no  longer  recognizable  under  the  names  of  the  accounts.  The 
distinction  between  these  two  methods  lies  in  the  simple  fact 
that  the  first  takes  out  of  operating  accounts  all  that  is  nominal 
only,  and  leaves  all  that  is  real,  and  the  second  takes  out  all 
that  is  real,  and  leaves  what  is  nominal.  In  the  first  case  what 
is  taken  out  is  carried  to  Loss  and  Gain,  and  in  the  second  what 
is  left  is  carried  to  Loss  and  Gain.  The  third  method  accom- 
plishes virtually  the  same  result  as  the  first,  but  works  directly 
on  the  ledger  without  journal  entries,  by  a  device  yet  to  be  ex- 
plained.   Any  combination  of  these  methods  may  be  used  also. 

Making  Operating  Accounts  Real.  This  is  well  illustrated  by 
the  entries  for  Fuel,  as  shown  for  both  the  cost-accounting  method 
and  the  inventory  method,  on  pages  57  and  72.  Fuel  was  origi- 
nally debited  for  $350,  but  at  the  end  of  the  period  two  new  facts 
necessarily  take  the  place  of  the  old  fact:  the  fuel  consimied  is 


214 


THE  FUNDAMENTALS  OF  ACCOUNTING 


$ioo,  and  must  show  on  the  operating  statement,  while  the  bal- 
ance of  fuel  which  the  new  year  inherits  is  $250,  and  this  must 
show  on  the  balance  sheet.  So  we  transfer  $100  from  Fuel  to 
Goods-in-Process,  or  Converted  Assets,  or  Loss  and  Gain,  and 
leave  $250  on  Fuel,  and  bring  down  this  balance  to  the  new  year. 
Since  we  are  now  concerned  with  the  technique,  rather  than  with 
the  substance  as  we  were  when  the  cases  came  up  before,  we  may 
well  here  observe  the  forms.  Let  us  3&rst  observe  the  ledger  ac- 
count for  Fuel  before  the  books  were  closed. 


Fuel 


Cash 


35000 


The  closing  entry  follows. 

Goods-in-Process 
(or  Converted  Assets) 
(or  Loss  and  Gain) 
To  Fuel 


100.00 


100.00 


When  this  entry  has  been  posted,  supposing  it  was  made  from 
journal  page  47,  and  Fuel  has  'been  balanced,  we  get  the  follow- 
ing: 

Fuel 


Cash 

Balance 
Dec.  31  iFud 


350 

350 
250 


00 


00 


Dec.  31 


Goods-in-Process 
Balance 


100 
250 


3SO 


Goods-in-Process 
47  lliooloo 


Now  our  ledger  shows  just  what  it  should:  Fuel  shows  statistically 
how  much  value  of  this  sort  we  have  handled  during  the  period, 
and  how  much  we  have  still  unconsiuned  and  available  for  the 
coming  period;  and  Goods-in-Process  shows  the  destination  of 
what  has  been  'converted.  Exactly  the  same  handling  is  correct 
for  the  Prepaid  Insurance.  A  different  result  follows  when  the 
asset  converted  has  not  been  put  upon  the  books  but  the  books 
are  now  to  be  brought  up  to  the  time.  Suppose  workmen  are 
paid  by  the  piece,  but  wages  cannot  be  paid  up  to  the  moment 
because  of  the  delay  incident  to  calculating  the  wages  due.    Sup- 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  215 

pose,  too,  that  we  have  debited  Wages  for  all  sums  paid  in  wages 
during  the  period,  $18,000,  but  have  not  yet  debited  Goods-in- 
Process.  In  closing  our  books,  then,  we  must  debit  Goods-in- 
Process  not  only  for  all  wages  paid  and  abready  debited  to  Wages, 
but  also  for  all  wages  earned  though  not  paid,  say  $500.  The 
entry  for  this  is 

Goods-in-Process  18,500 

To  Wages  18,500 

We  now  have  a  credit  balance  of  $500  on  Wages.  This  consti- 
tutes a  liability,  the  excess  of  assets  secured  over  the  payment 
made  for  those  assets,  and  hence  an  ownership-claim  of  our  em- 
ployees for  wages.  We  have  thus  made  our  Wages  real  just  £ls  we 
made  Fuel  real,  by  transferring  to  Goods-in-Process,  Converted 
Assets,  or  Loss  and  Gain,  that  which  was  nominal  and  leaving  as  a 
balance  that  which  represented  assets  and  liabilities.  In  the  case 
of  Fuel  our  final  balance  represented  an  asset,  and  here  it  repre- 
sents a  liability.  This  is  not  all,  however.  We  are  concerned 
also  with  the  effect  on  Wages  for  the  next  period.  The  account 
for  the  new  period  begins,  as  we  have  just  seen,  with  a  credit  bal- 
ance, and  it  is  a  real  account.  Suppose  in  the  subsequent  period 
we  continue  to  use  this  same  account  for  wages  of  the  period,  as  a 
nominal  account,  debiting  it  for  payments  made  and  crediting  it 
for  earnings  of  employees.  The  wages  paid  first  in  the  new  period 
will  be  those  due  from  the  previous  period.  When  they  have  been 
entered  as  paid,  the  account  will  have  no  balance,  of  course;  and 
this  is  as  it  should  be.  This  debit  made  in  the  new  period  is  not 
for  work  done  in  the  new  period,  and  hence  should  be  offset  by 
a  credit  —  giving  the  account  immimity  for  that  which  is  thrust 
upon  it  for  the  accommodation  of  the  old  period.  The  new  period 
confers  a  benefit  on  the  old,  and  should  be  given  credit  for  it. 
Since,  moreover,  it  is  known  beforehand  that  the  new  period  will 
have  to  pay  for  the  old,  that  credit  is  actually  given  in  advance 
when  the  books  are  closed,  and  automatically  the  records  are  ad- 
justed. 

Making  Operating  Accounts  NominaL  The  cases  of  Fuel  and 
Wages  used  above  may  well  be  used  also  to  illustrate  closing  by 
making  operating  accounts  nominal.  Here,  instead  of  leaving  the 
real  elements  in  the  account  to  be  closed  (as  a  balance  ready  for 


2l6 


THE  FUNDAMENTALS  OF  ACCOUNTING 


the  new  period)  and  carrying  the  nominal  portion  to  Goods-in- 
Process,  Converted  Assets,  or  Loss  and  Gain,  we  shall  carry  the 
real  portion  in  each  case  to  a  new  account,  leaving  the  nominal 
portion  temporarily  in  the  old  accoimt,  and  then  transfer  the 
balance  of  the  old  account  (now  nominal)  to  Goods-in-Process, 
Converted  Assets,  or  Loss  and  Gain.  Without  further  explana- 
tion the  entries  follow. 


Fuel  Inventory- 
To  Fuel 

250 

250 

Goods-in-Process 

100 

To  Fuel 

100 

Wages 

To  Wages  Liability 

500 

sod- 

Goods-in-Process 

18,500 

To  Wages 

18,500 

The  ledger  follows. 

Fuel 

Cash 

3SO 

Dec.  31 

Fuel  Inventory 
Goods-in-Process 

47 
47 

250 
100 

350 

350 

Fuel  Inventory 

Dec.  31    Fuel                         47      250 

Wages 

Cash 

18,000 

Dec.  31 

Goods-in 

-Process 

47 

18,500 

Dec.  31 

Wages  Liability 

47 

500 

18,500 

18,500 

1                               1    II 
W 

AGESL 

[ABILITY 

- 

Wages 

47       500 

Goods-in-Process 

Dec.  31 

Fuel 
Wages 

47 
47 

100 
18,500 

The  essential  difference  between  the  two  methods  lies  in  the  place 
and  title  of  the  real  accoimts  after  the  books  are  closed.  Shall  the 
inventories  and  liabilities  stand,  at  the  time  the  balance  sheet  is 
taken,  in  accounts  that  never  contain  anything  else  and  that  carry 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  ^l^ 

distinct  titles,  or  shall  they  be  in  accounts  to  which  other  things 
are  carried  and  which  therefore  bear  less  specific  titles?  Under 
the  first  method,  the  first  item  for  any  period  is  the  amount 
brought  from  the  preceding  period  (provided  any  such  balance 
remained) ;  and  hence  confusion  is  not  likely  to  arise.  Under  the 
second  method,  confusion  cannot  arise  with  proper  precautions, 
but  extra  labor  is  involved;  for  sooner  or  later  the  balance  carried 
over  to  the  new  period  in  a  separate  account  must  be  consolidated 
with  the  new  items  of  that  period,  and  this  means  transferring 
the  inventory  or  liability  to  the  operating  account  of  the  new 
period  by  a  process  just  the  reverse  of  that  by  which  it  was  taken 
out  of  the  operating  accoimt  of  the  old  period.  Instead  of  coming 
down  simply  as  a  balance  to  the  new  period,  it  is  taken  out  of  the 
old,  put  into  a  special  account,  and  then  put  into  the  account  for 
the  new  period. 

Direct  Ledger  Closing.  Under  this  method  adjustment  items 
are  put  into  the  ledger  without  journal  entry:  they  do  not  consti- 
tute record  of  transactions,  but  merely  record  the  fact  that  in  the 
adjustment  between  earning  periods  certain  items  already  paid  do 
not  belong  to  the  period  in  which  they  were  paid  but  to  a  later 
period,  and  that  certain  items  belong  to  the  present  period  though 
they  will  actually  get  into  transactions  only  in  a  later  period.  In 
our  fuel  illustrations  just  used,  though  $350  has  been  spent  for 
fuel,  only  $100  need  be  considered  in  closing  the  accounts  for  this 
current  period,  and  $2 50  must  be  considered  in  a  later  period.  By 
this  method,  it  may  be  said  that  the  process  of  closing  the  books 
is  not  only  an  accounting  but  a  mechanical  method  of  drawing  a 
line  of  cleavage  between  two  earning  periods.  By  this  method 
we  directly  carry  each  to  its  own  place  without  ado;  but  in  order 
to  show  that  all  fuel  is  now  accounted  for,  we  must  show  how 
its  account  is  balanced.  So  we  enter  (in  red,  preferably)  on  the 
credit  side  the  amounts  transferred  to  the  debits  of  the  appro- 
priate accounts  concerned.  That  is,  we  enter  our  balances  as  we 
did  on  page  214,  except  that  here  we  have  two  balances,  separate 
parts,  with  different  destinations  because  of  the  split  between 
periods.  Since,  however,  the  account  for  fuel  of  1920  is  dead  on 
Dec.  31,  1920,  we  do  not  need  to  carry  our  balance  of  $250  to 
an  account  with  "1921"  in  it,  but  bring  it  down  simply  as  a 


2l8 


THE  FUNDAMENTALS  OF  ACCOUNTING 


balance  on  Fuel,  for  all  fuel  after  Dec.  31,  1920,  must  be  192 1  or 
later.    Following  is  the  illustration. 

Fuel  fpage  i« 


Cash 

Balance 
Dec.  31  I  Fuel 


350 


350 


Dec.  31 


Inventory 
Goods-in-Process 


250 

Goods-in-Process 

L12II  lool 


L28 


259 

zoo 

350 


[page  28 


Strictly  speaking,  the  $350  debited  to  Fuel  is  split  into  two  parts, 
one  part  is  carried  down  to  the  new  Fuel,  and  the  other  to  Goods- 
in-Process,  and  the  credit  items  are  to  show  just  how  the  account 
is  balanced.  The  reason  for  not  making  a  journal  entry  is  simply 
that  no  transaction  is  involved,  and  that  we  are  merely  spUtting 
the  $350,  already  recorded,  between  two  periods.  Our  wages 
item  is  in  a  sense  a  reverse  case.  Here  we  have  to  carry  to  Goods- 
in-Process,  or  Converted  Assets,  or  Loss  and  Gain,  not  only  all 
that  has  been  debited  but  more.  We  are  splitting  not  the  asset 
that  we  got  for  our  costs,  but  the  payment  that  is  made  for  them 
—  $18,000  paid  this  year  and  $500  to  be  paid  next  year.  Our 
whole  $18,500  must  be  carried  to  the  summary  operating  account 
(Goods-in-Process,  or  Converted  Assets,  or  Loss  and  Gain),  of 
course,  but  this  will  not  balance  our  account,  and  should  not. 
A  part  of  next  year's  payments  are  chargeable  to  this  year's  busi- 
ness. We  might  make  a  journal  entry,  debiting  Wages  1920  for 
what  has  yet  to  be  paid  for  1920,  and  crediting  Wages  1921  —  on 
the  ground  that  the  work  done  in  1920  is  an  asset  and  as  192 1  will 
pay  the  bills  it  should  be  credited.  When  the  pay  roll  is  met  in 
1 92 1,  Wages  will  in  the  natural  course  of  events  be  debited, 
though  part  of  that  payment  is  for  work  done  in  1920:  hence 
Wages  of  192 1  should  now  be  credited  for  taking  over  a  burden  of 
1920  —  for  paying  bills  that  confer  a  benefit  on  the  business  of 
1920.  We  can  do  all  this  without  journal  entries,  however,  and 
we  are  justified  in  it  since  the  record  is  not  for  new  transactions 
but  for  a  mere  split  between  periods.  We  therefore  close  our  old 
Wages  by  entering  (preferably  in  red)  $500  on  the  debit  side,  for 
the  wages  accrued  not  yet  paid,  really  a  balance  that  we  are  to 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS 


219 


carry  to  the  new  Wages  (for  192 1),  and  $18,500  on  the  credit  side 
(also  preferably  in  red),  a  balance  that  we  are  to  carry  to  Goods- 
in-Process,  or  Converted  Assets,  or  Loss  and  Gain.  When  this 
has  been  done  and  the  amounts  designated  have  been  so  trans- 
ferred, we  get  the  ledger  (for  these  items)  as  follows: 

Wages  [page  14 


Dec  31 


Cash 
Liabiliiy 


18,000 
500 


18,500 


Dec.  31 


Goods-in-Process 


Balance 


L28 


18,500 


18,500 


Dec.  31  I  Wages 


Goods-in-Process 
[L14  |li8,5oo|||  I 


500 
[page  28 


When  items  are  transferred  in  this  way,  the  index  figure  is  the 
ledger  page  from  which  and  to  which  transferred,  of  course,  in- 
stead of  the  journal  page  from  which  posted.  The  balance  on 
Wages,  being  now  real,  represents  sums  due  for  wages,  exactly  as 
if  the  names  of  the  individuals  to  whom  money  was  owed  for 
wages  appeared  in  ledger  accoimts  with  credit  balances  —  owner- 
ship-claims. 

Comparison  of  Methods.    It  is  now  worth  while  to  examine  the 
ledger  under  each  of  the  three  methods  and  note  differences.    For 
this  purpose  the  accounts  for  fuel  are  repeated  below: 
[Method  I]  Fuel 


Cash 


Balance 


• 

350 

Dec.  31 

350 

250 

[Method  II] 

Cash 


Fuel 


[Method  III] 
Cash 


Fuel 


350 


350 


Dec.  31 


Goods-in-Process 

Balance 


Fuel  Inventory 
Goods-in-Process 


47 
47 


100 
250 

350 


250 
100 
3SO 


Fuel  Inventory 
47    I  250 


Fuel 


Balance 


350 


350 
250 


Dec.  31 


Inventory 
Goods-in-Process 


L28 


250 
100 

350 


220  THE  FUNDAMENTALS  OF  ACCOUNTING 

From  this  case  it  is  obvious  that  the  difference  in  appearance 
on  the  ledger  is  negligible.  The  index  references  differ,  of  course; 
the  term  used  in  the  explanation  column  for  inventory  differs 
slightly;  the  color  of  ink  (if  one  uses  red)  differs  from  form 
to  form;  in  one  case,  the  inventory  is  in  a  separate  account  substi- 
tuted for  the  regular  account.  Here  the  differences  end.  In 
other  words,  they  are  negligible  except  for  matters  of  taste.  One 
combination  of  methods  suggests  itself:  carrying  the  inventory  to 
an  inventory  account  by  journal  entry,  and  then  carrying  the 
balance  of  the  accoimt  (the  nominal  portion)  to  Goods-in-Process 
(or  its  substitute)  by  direct  ledger  transfer.  This  would  not  give 
a  new  result,  however,  but  only  a  different  combination  of  items 
in  the  results  shown  above.  It  will  be  noted  that  Goods-in- 
Process  is  identical  in  the  three  cases  except  for  the  index  refer- 
ence, journal  page  47  in  two  cases  and  ledger  page  12  in  one;  and 
hence  it  is  not  repeated  here.  With  respect  to  the  illustration 
with  Wages,  we  again  get  virtually  the  same  result  under  the 
three  methods  —  the  same  differences  as  with  Fuel. 

Comment  on  Methods  I  and  n.  Theoretically  the  choice  be- 
tween the  first  and  the  second  method  (making  the  account  real, 
and  making  it  nominal)  is  neghgible.  Practically,  each  has  its 
advantages  and  its  disadvantages.  When  the  first  is  used,  the 
inypitory^-or4iabiiitj^-a44he^eginn^ 
ram>H  into  the  arrnnnt  fnr  tha-^M^w^enoH ^  k  fopf^nliHatpH  with 

thenew  items  for  the  period,  and  can  be  used  statistically  later 
only^wheaJdentified*  Under  the  second  methodTrElTin  an  ac- 
count by  itself,  and  is  therefore  always  available  for  statistical 
use,  even  if  it  is  inamediately  transferred  to  the  operating  account 
for  the  new  period  (for  accounts  transferred  preserve  their  original 
figures,  of  course,  but  have  them  offset  by  entries  on  the  other 
side).  The  transfer  to  the  operating  account  for  the  new  period 
may  be  postponed  even  to  the  end  of  the  new  period;  and  this  is 
often  done  when  the  new  items  of  the  new  period  are  desired 
statistically  separate  from  the  items  inherited  from  the  old  pe- 
riod. One  disadvantage  from  this  separation,  besides  the  addi- 
tional bother  of  closing  the  inventory  account  out  to  the  new 
operating  account  as  already  mentioned,  is  the  fact  that  if  the  in- 
ventory is  not  at  once  closed  out  to  the  new  operating  aGcoimt_(in 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  221 

which  case  there  is  virtually  no  advantage  in  having  it  in  a  sepa- 
rate account  at  all),  it  remains  on  the  books  as  an  inventory  long 
after  it  ceases  to  have  any  validity  as  an  inventory  and  is  likely  to 
naislead.  The  protection  against  this  is  to  give  the  title  a  date,  as 
Merchandise  Inventory,  Jan.  i,  1923.  In  the  case  of  liabilities, 
moreover,  unless  they  are  at  once  closed  to  the  new  account,  a 
new  inconvenience  arises  from  the  fact  that  if  a  separate  account 
is  set  up,  as  for  wages  liability  just  illustrated,  care  must  be  taken 
to  observejjwhe&-wages-are^paid77ust  what  amounts  are  paid  on 
olditems^ andJio^jdebit JS^ages  JiabULtxand^^  Wages  for  them 
—  else  Wages  will  be  twice  debited  for  the^ame^thingy  once  when 
the  Hability  was  entered  and  again  when  it  was  paid.  If,  on  the 
other  hand,  the  first  or  the  third  method  is  used,  this  inconven- 
ience will  not  arise,  for  the  liability  is  shown  directly  on  the  new 
operating  account  as  a  credit,  reducing  by  so  much  the  net  effect 
of  the  debits  for  items  paid  in  the  subsequent  year  (because  this 
amount  though  to  be  paid  in  that  year  is  a  charge  against  the  pre- 
ceding year  and  immunity  is  given  in  advance).  Where  esti- 
mated figures  rather  than  known  figures  are  used  for  adjustment, 
however,  the  second  method,  carrying  the  liability  to  a  new  ac- 
coimt  and  keeping  it  until  paid,  is  the  only  accurate  method. 
This  is  well  illustrated  by  the  case  of  allowance  for  discoimts,  as 
discussed  below. 

Closing  Accounts  with  Allowances.  As  pointed  out  in  Chapter 
Vni,  the  provision  of  an  allowance  for  discounts  available  to 
customers  at  the  end  of  a  period,  on  sales  of  the  period,  necessi- 
tates care  that  the  discoimts  be  not  again  debited  as  deductions 
from  actual  selling  price  when  the  bills  are  paid.  So  when  the 
discounts  are  actually  given  the  debit  is  to  Allowance  for  Dis- 
count Offered  and  not  to  Discoimt  Given.  This,  however,  means 
observation  at  each  settlement  of  bills  to  distinguish  between 
those  of  the  previous  period  and  those  of  the  new.  Let  us  sup- 
pose, on  the  other  hand,  that  at  the  beginning  of  the  new  period 
the  allowance  for  discounts  offered  credited  at  the  end  of  the  old  is 
at  once  transferred  to  Discount  Given,  thus  giving  this  account 
of  the  new  period  immunity  in  advance  for  the  discount  belong- 
ing to  the  old  period;  let  us  suppose  further  that  all  discounts 
given  in  the  new  period,  whether  on  old  or  new  sales,  are  debited 


222  THE  FUNDAMENTALS  OF  ACCOUNTING 

to  Discount  Given;  clearly  if  all  the  old  discounts  offered  are  taken 
by  customers  the  debit  balance  on  Discount  Given  will  show 
the  new  discounts  given;  but  if  any  of  the  old  discounts  offered 
are  forfeited  the  immunity  given  in  advance  will  be  excessive 
and  will  destroy  by  so  much  the  significance  of  the  debit  bal- 
ance on  Discount  Given.  Then  we  shall  not  know  either  how 
much  discount  was  actually  taken  on  sales  of  the  new  year  or 
how  much  of  the  discount  offered  on  sales  of  the  old  year  was 
forfeited  to  us  as  an  extra  gain.  This  method  will  not  give  us 
satisfactory  statistical  information,  therefore.  The  same  sort 
of  thing  is  true,  of  course,  for  Allowance  for  Discount  Available. 
When,  therefore,  the  amount  of  an  allowance  is  a  mere  estimate 
of  something  belonging  to  the  old  year  but  not  ascertainable  ac- 
curately until  the  new,  the  method  of  bringing  down  the  old  allow- 
ance immediately  to  the  account  for  the  new  year  and  making 
thereafter  no  distinction  between  old  items  and  new  not  only 
makes  impossible  a  test  of  the  accuracy  of  the  old  allowance  and 
so  destroys  its  value  as  a  guide  for  the  future,  but  prevents  ac- 
curate statistics  for  the  new  year.  This  has  already  been  fully 
illustrated  in  connection  with  Allowance  for  Bad  Debts,  on 
pages  124-126. 

Comment  on  Method  m.  Jhe^general^omment  often  made 
upon  Method  III  is  thatJJLisJrregulaxjind  unconventional  be- 
caj^eJedgeijtemsaTe^ni^redjdfe^  in  books  of 

original  enjjy.  This  is  finical,  since,  as  has  already  been  sug- 
gested, the  adjustment  entries  of  the  kind  just  discussed  are  not 
for  transactions  but  for  division  of  costs  between  periods.  The 
second  objection  is  that  rQcordxMitheledgk'-^^uehritenisi/dthout 
record  of  where  they  come  from  is  likely  to  lead4Q^inac€iiracy  in 
the  first  ^aS^^djinprobability  that  error  will  be  discovered. 
The  answer  to  this  is  that  any  desirable  memoranda  supporting 
such  ledger  items  may  be  entered  in  the  journal  as  memoranda 
(not  extended  into  money  colunms),  without  the  formality  of 
posting.  The  third  objection  isLlhat_the=^justments-are  not 
summarized  in  iiny.  .one.  place  for  reference  (as  they  are  when 
journal  entries  are  made,  naturally  following  one  another  in  im- 
mediate succession),  but  are  scattered  through  all  the  accounts 
concerned,  each  having  its  own  adjustment  and  that  adjustment 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  223 

going  nowhere  else  except  usually  to  Loss  and  Gain  (or  its  substi- 
tutes). Under  the  journal  methods  of  closing,  the  detailed  items 
of  Loss  and  Gain  would  be  in  the  journal  and  usually  only  the 
total  of  each  side  would  be  in  the  ledger;  but  imder  the  direct 
ledger  method  of  closing  the  details  of  Loss  and  Gain  would  be  on 
the  ledger  account,  because  they  would  be  transferred  one  by  one 
from  different  sources  to  that  account.  The  task  of  closing  is 
simpler  by  the  direct  ledger  method,  of  course,  for  less  writing  is  re- 
quired, and  comparatively  few  adjustments  need  explanation;  and 
when  the  items  to  be  adjusted  are  not  numerous,  so  that  they  can  be 
readily  found  for  reference  on  the  ledger  itself,  this  is  an  excellent 
method.  When,  on  the  other  hand,  many  items  need  explanation 
and  many  items  need  adjustment,  and  therefore  a  summary  view 
would  be  hard  to  get  from  the  ledger  alone  because  they  would 
be  scattered,  one  of  the  journal  methods  of  closing  is  preferable. 

Forms  Preliminary  to  Closing  the  Ledger.  Often  many  items 
need  adjustment  before  the  closing  is  complete,  and  every  adjust- 
ment has  two  effects  —  as  everything  in  double  entry  has  a  dou- 
ble aspect.  It  is  difficult  to  carry  many  items  through  without 
neglecting  or  duplicating  something.  Particularly  is  this  so  when 
a  succession  of  adjustments  hinge  on  one  another  —  as  closing 
Freight  to  Fuel,  Fuel  to  Power,  Power  to  Goods-in-Process,  etc. 
If  the  adjustment  of  Freight  is  wrong,  all  subsequent  items  in  this 
series  are  wrong.  It  is  not  usually  safe,  therefore,  to  go  on  with 
the  closing  process  until  the  whole  procedure  has  been  planned 
ahead  and  tested  by  balance-sheet  and  income-sheet  figures 
worked  out  from  the  outlined  plan  and  foimd  consistent. 

Form  of  Six-Column  Statement.  The  simplest  of  forms  for 
assistance  in  closing  the  books  has  six  colunms,  two  for  the  trial 
balance  as  it  stands  before  adjustments,  two  for  the  balance- 
sheet  figures  (after  adjustment,  of  course),  and  two  for  the  oper- 
ating-statement figures  (after  adjustment).  The  items  of  the 
trial  balance  which  represent  assets  or  liabilities  just  as  they 
stand,  i.e.,  pure  real  accounts,  are  extended  in  the  asset  and  liabil- 
ity columns  without  change.  The  items  which  are  purely  nomi- 
nal and  are  complete  to  the  time  of  the  trial  balance  are  extended 
into  the  operating-statement  columns  without  change.  The 
piixed  items,  those  which  are  behind  or  ahead  of  the  time,  are 


224 


THE  FUNDAMENTALS  OF  ACCOUNTING 


not  extended  into  other  columns,  but  the  amounts  to  be  extended 
from  them  are  derived  from  the  trial-balance  figures  by  such  ad- 
justment as  may  be  necessary.  Below  is  a  six-column  statement 
for  a  simple  mercantile  business  having  only  a  single  account  for 
merchandise.  *  !s}  ^0 


H:/^mn 


umn  Statement 


Dr. 

Cr. 

Re- 
sources 

Liabil- 
ities 

Losses 

Gains 

1  Proprietor 

30,000 

30,000 

2  Cash 

15,000 

15,000 

3  Accounts  Receivable 

18,000 

18,000 

4  Merchandise 

1^600 

20^00 

18,400 

5  Accounts  Payable 

13,000 

13,000 

6  Notes  Payable 

8,000 

8,000 

7  Rent 

3,000 

3,000 

8  Taxes 

Soo 

50 

450 

9  Wages 

13,000 

600 

13,600 

10  Interest 

100 

25 

75 

51,100 

51,100 

53,050 

51,625 

17,050 

18,475 

Total  Resources 
Total  Liabilities 
Net  Gain 


Proof 
53,050    Total  Gains 
51,625    Total  Losses 
1,425  Net  Gain 


i8,47S 

17,050 

1,42s 


The  figures  for  the  first  three  accounts,  and  for  the  fifth  and  the 
sixth,  are  obvious,  for  the  accounts  are  real,  need  no  adjustments, 
and  accordingly  give  exact  items  for  the  resource  and  the  liability 
column.  The  seventh  similarly  gives  a  figure  for  the  loss  column 
(converted-assets  debit). 

Merchandise.  The  debit  balance  of  Merchandise  shows  that 
the  total  charged  to  Merchandise  is  more  than  has  been  got  back; 
but  we  do  not  know  how  much  merchandise  still  remains  unsold. 
If  the  amount  unsold  is  worth  at  cost  price  $1 ,600,  the  handling  of 
merchandise  has  resulted  in  neither  gross  profit  nor  loss;  for  what 
we  have  left  just  equals  what  all  our  merchandise  cost  us  less  what 
we  have  got  back.  If,  on  the  other  hand,  what  we  now  have  on 
hand  is  worth  at  cost  price  more  than  $1,600,  it  is  obvious  that  we 
have  made  some  gross  profit;  for  if  we  had  no  merchandise  left  our 
loss  would  be  only  $1,600.  To  put  this  in  another  way,  the  im- 
recovered  cost  of  what  we  have  on  hand  is  $1,600,  or  the  net 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  225 

debit  to  the  account.  If  the  goods  on  hand  actually  cost  more 
than  $1 ,600,  the  difiference  is  gross  profit  realized  from  selling  some 
of  our  goods  for  more  than  they  cost,  thus  reducing  the  net  bal- 
ance of  the  account  to  less  than  the  cost  of  the  remainder.  The 
profit  does  not  lie  in  having  on  hand  worth  $20,000  (as  shown 
by  the  resource  column)  merchandise  that  cost  only  $1,600,  but 
in  having  sold  (the  amount  being  here  unknown)  some  of  the 
merchandise  at  a  price  so  far  above  cost  that  the  balance  remain- 
ing now  stands  net  far  below  cost.  If  we  could  know,  for  ex- 
ample, that  the  $1,600  debit  balance  came  from  $86,600  debits 
and  $85,000  credits,  and  that  we  have  still  on  hand  $20,000  at  cost 
price,  we  could  at  once  see  that  what  cost  us  $66,600  ($86,600- 
$20,000)  was  sold  for  $85,000,  and  that  therefore  our  gross  profit 
is  $18,400.  Without  actual  figures  of  purchases  and  sales,  i.e., 
using  the  short-cut,  we  merely  say  that  the  net  cost  of  what  we 
have  is  $1,600,  and  as  it  is  worth  (at  cost  price)  $20,000,  our 
profit  from  what  we  sold  was  $18,400.  This  is  a  convenient  way 
of  figuring  it;  but  logically  it  is  wrong,  for  we  make  profit  not  on 
what  we  keep  but  on  what  we  sell.  For  purposes  of  finding  profit 
on  a  six-column  statement,  however,  it  is  satisfactory.  We  ac- 
cordingly on  our  form  show  the  inventory  at  the  end  of  the  period 
in  the  resource  column,  and  extend  the  resulting  gross  profit  into 
the  gain  colmnn.  As  a  convenience  for  the  eye,  all  items  of  re- 
source or  liability  resulting  from  adjustment,  and  therefore  not 
agreeing  with  trial-balance  figures,  may  well  be  in  red  —  to  show 
that  they  were  not  altered  inadvertently. 

Taxes.  Taxes  needs  adjustment.  Though  $500  has  been  paid 
during  this  period,  $50  of  the  amount  has  not  yet  been  consumed, 
or  can  be  realized  upon  later  (perhaps  a  rebate  is  allowable),  or 
was  paid  in  advance  of  the  period  for  which  levied.  So  not  all  of 
this  is  chargeable  to  the  period.  The  asset  portion  is  carried  in 
the  resource  column,  and  the  consimaed  portion  in  the  loss  column. 

Wages.  The  debits  have  not  covered  all  the  costs  of  the  period, 
for  we  find  a  HabiHty  of  $600.  This  is  extended  in  the  hability  col- 
umn. Then  this  Uability  is  added  to  the  debits  shown  by  the  trial 
balance,  and  the  sima  is  the  charge  for  the  period,  extended  as  loss. 

Interest.  Earnings  from  interest  are  shown  by  the  books  to  be 
$100 ;  but  we  also  find  a  liability  for  $25.    This  may  be  either  a  lia- 


226  THE  FUNDAMENTALS  OF  ACCOUNTING 

bility  to  pay  interest  of  $25,  reducing  the  net  earning  to  $75,  or  it 
may  be  recognition  of  the  fact  that  interest  has  been  paid  to  the 
business  in  advance  and  that  $25  of  this  has  not  yet  been  earned, 
for  the  business  is  responsible  to  allow  further  use  of  its  money 
without  further  compensation  —  and  hence  a  part  of  this  $100 
will  be  an  earning  of  a  later  period  after  the  obligation  to  allow  the 
loaned  money  to  be  used  is  fulfilled.  In  either  case,  only  $75  has 
been  earned  in  the  period,  and  $25  is  the  amount  for  which  the 
business  is  liable  —  to  pay,  to  repay,  or  to  allow  in  the  use  of  its 
funds — and  hence  constitutes  some  ownership-claim.  The  items 
are  extended  accordingly. 

The  Proof.  If  we  have  started  with  a  correct  trial  balance  and 
have  entered  properly  all  adjustments  and  final  dispositions  of 
items,  our  six-column  statement  must  be  in  balance,  for  we  have 
kept  the  double  aspect  of  double  entry  throughout.  In  every 
case  we  have  either  used  a  trial-balance  figure  as  it  was,  or  have 
made  in  it  an  adjustment  which  got  into  both  the  resource-liabil- 
ity and  the  loss-gain  set  of  columns.  When,  for  example,  we 
raised  the  merchandise  figure  from  $1,600  to  $20,000,  we  changed 
the  loss-gain  figure  from  $1,600  loss  to  $18,400  gain;  when  we  re- 
duced the  tax  loss  from  $500  to  $450,  we  also  increased  the  re- 
source by  $50;  when  we  showed  $600  liability  for  wages,  we  in- 
creased our  loss  by  $600;  when  we  showed  a  liability  of  $25  for 
interest,  we  reduced  our  gain  by  $25.  So  always  we  kept  our 
changes  in  double  entry.  In  the  end,  then,  the  net  assets  must 
equal  the  proprietor's  ownership-claim.  We  started  with  the 
proprietor's  ownership-claim  before  adjustment  was  made,  and 
have  carried  all  changes  of  his  ownership-claim  in  the  form  of 
profit  or  loss  into  the  loss  or  the  gain  column.  It  must  follow  that 
the  excess  of  total  assets  over  total  liabilities  (including  the  pro- 
prietor's ledger  balance  of  ownership-claim,  before  adjustment, 
as  a  liability)  is  the  increase  of  net  assets  for  the  period.  Since 
the  loss  and  gain  items  show  the  operating  figures,  as  subdivisions 
of  the  proprietor's  profit-claim,  it  also  follows  that  the  excess  of 
total  gains  over  total  losses  is  the  increase  in  proprietor's  owner- 
ship-claim for  the  period.  These  two  things,  moreover,  are  the 
two  aspects  of  the  same  thing  —  the  growth  of  assets  and  the 
growth  of  ownership  of  assets.    So  they  must  be  equal.    The  six- 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS 


227 


column  statement  may  well  show  that  test,  as  above.  When  the 
figures  are  proved  in  this  way,  one  is  ready  to  go  on  and  close  the 
ledger,  incorporating  the  adjustments  and  the  closing  items  upon  it, 
by  one  of  the  methods  described  above,  with  assurance  that  things 
will  go  smoothly  and  produce  right  results  if  due  care  is  taken. 
Another  Illustration.  Let  us  take  next  another  illustration 
more  complicated.  We  will  use  again  the  figures  of  the  problem 
used  for  illustration  of  the  inventory  method  of  getting  an  operat- 
ing statement,  in  Chapter  VII,  starting  before  any  adjustment 
and  closing  entries  were  made.  The  trial  balance  of  these  figures 
would  give  in  the  trial-balance  colimans  those  that  follow  below. 
It  will  be  remembered  that  the  following  facts  were  not  shown  on 
the  books  before  their  adjustment:  inventories  —  raw  material, 
$3,500;  fuel,  $250;  insurance  prepaid,  $225;  goods-in-process, 
$2,205;  finished  goods,  $600:  liability — royalties,  $280. 

Six-Column  Statement 


Proprietor 

Cash 

Raw  Material 

Wages 

Insurance  Prepaid 

Fuel 

Rent 

General  Expenses 

Accounts  Receivable 

Sales 


Royalty 

Goods-in-Process 
Finished  Goods 


Total  Resources 
Total  Liabilities 
Net  Gain 


Dr. 

Cr. 

Re- 
source 

LiabU- 
Uy 

Loss 

Gain 

8,000 

8,000 

300 
S,ooo 
1,400 
300 
3SO 
200 

300 
3,500 

225 
250 

I,S0O 

1,400 

75 
100 
200 

450 
1,700 

1,700 

1,700 

280 

450 
280 

1,700 

9,700 

9,700 

2,205 
600 

2,205 
600 

8,780 

8,280 

4,00s 

4,505 

Proof 


8,780 

8,280 

Soo 


Total  Gains 
Total  Losses 
Net  Gain 


4,505 

4,005 

500 


Other  Forms.  When  adjustments  are  numerous,  and  consist 
not  merely  of  splitting  items  between  periods  and  carrying  all 
operating  figures  to  Loss  and  Gain  (or  its  substitutes),  but  of 


228  THE  FUNDAMENTALS  OF  ACCOUNTING 

closing  accounts  in  series,  one  account  to  another,  and  then  that  to 
a  second,  and  this  in  turn  to  a  third,  confusion  is  likely  to  arise  from 
closing  an  account  before  all  adjustments  have  been  made  in  it,  or 
leaving  it  open  too  long.  Adding  columns  to  the  six-column  state- 
ment to  show  and  test  the  necessary  adjustments  is  likely  to  prevent 
the  need  for  correction  entries,  for  then  errors  will  be  discovered 
before  they  have  been  incorporated  on  the  books  themselves. 

The  Eight-Column  Statement.  The  eight-column  statement 
adds  two  columns  immediately  after  the  trial-balance  columns 
for  adjustments  that  are  to  be  made  by  journal  entries,  such  as 
depreciation,  interest  accrued  on  securities  owned,  and  interest 
allowed  on  partners'  balances.  Such  adjustment  items,  however, 
preferably  should  not  include  transferring  losses  and  gains,  or 
costs  and  yields,  to  Goods-in-Process,  or  Converted  Assets,  or 
Loss  and  Gain,  for  then  the  loss  and  gain  columns  of  the  state- 
ment would  have  virtually  no  entries  (for  the  items  would  have 
been  transferred  to  the  summary,  or  clearing,  account  by  the  ad- 
justments, and  only  the  final  net  figure  would  be  left  for  the  loss 
and  gain  columns) ;  and  we  should  have  the  summary  information 
of  an  income  sheet  rather  than  the  detailed  information  of  an 
operating  statement.  So  only  adjustments  or  transfers  short  of 
closing  to  the  final  loss  and  gain  account  should  be  put  through 
the  adjustment  columns.  This  device  of  adjustment  columns, 
however,  if  worth  while  at  all  because  adjustments  are  niunerous,  is 
usually  worth  carrying  further,  so  as  to  show  the  new  trial  balance 
after  adjustment,  ready  to  give  figures  for  the  balance-sheet  and  op- 
erating-statement columns.  This  gives  us  a  ten-colunm  statement. 

The  Ten-Column  Statement.  The  ten-column  statement,  as 
we  have  seen,  differs  from  the  eight-column  statement  in  having 
two  columns  for  the  new  trial  balance  after  the  adjustments  pro- 
vided for  in  the  eight-colujnn  statement  have  been  made.  A 
time  when  the  ten-column  statement  is  likely  to  be  particularly 
serviceable  is  when  various  departments  are  run  independently 
but  are  to  share  certain  expenses  common  to  several  or  all  of  them, 
through  a  clearing  accoimt,  and  it  is  desirable  to  show  on  such  a 
statement  the  figures  for  the  balance  sheet  and  operating  state- 
ment (the  latter  comprising  virtually  department  figures  only). 
An  illustration  follows. 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  23 1 

notes  are  not  worth  face  value,  and  theoretically  should  not 
stand  on  balance  sheets  at  such  value.  K  we  are  to  set  up  an 
allowance  for  this  fact,  however,  we  sh<^ld  also  set  up  the  con- 
trary allowance  for  notes  payable  not  yet  due  and  never  dis- 
counted. Then,  logically,  we  shall  see  that  if  we  are  to  figure 
discount  on  notes  given  for  bills  for  merchandise,  both  receiv- 
able and  payable,  we  should  theoretically  also  figure  discount  on 
bills  for  which  notes  have  not  been  given;  for  a  bill  collectible  in 
two  months  is  worth  less  to-day  than  one  due  to-day.  This, 
however,  would  usually  involve  a  tremendous  amount  of  labor 
and  would  not  usually  produce  enough  difference  on  the  balance 
sheet  to  make  it  worth  while.  It  is  not  usually  done  imless  a 
final  settlement  is  about  to  be  made,  as  when  a  new  partner  is  to 
be  taken  in,  or  a  partner  is  retiring,  or  a  business  is  sold.  The 
cx)mplementary  entry  is  to  the  appropriate  interest  account. 


QUESTIONS  AND  PROBLEMS 

The  merchandise  account  on  the  general  ledger  is  debited  for  $150,000 
and  credited  for  $100,000.  The  merchandise  inventory  is  $75,000. 
By  each  of  the  three  methods  of  closing  the  ledger,  dose  the  merchandise 
account  and  carry  the  profit  or  loss  to  Loss  and  Gain.  Show  complete 
index  references. 
From  the  information  given  below  construct  a  six-column  statement. 


Trial  Balance  of  A  ^  B  Co, 

Proprietor  A 

S7,ooo 

Proprietor  B 

25,000 

Bills  Payable 

19,000 

Bills  Receivable 

27,000 

Accounts  Receivable 

20,000 

Accounts  Payable 

25,000 

Real  Estate 

4S,ooo 

Merchandise 

4,000 

Commission 

3,000 

Interest 

1,000 

Wages 

35,000 

Expense 

5,000 
133,000 

133,000 

The  real  estate  is  now  worth  $44,500;  the  merchandise  inventory 
is  $51,000;  commission  is  owed,  $1,000;  wages  are  owed,  $500;  $500 
is  owed  for  expenses;  interest  is  accrued  in  favor  of  the  business, 
$500. 


232 


THE  FUNDAMENTALS  OF  ACCOUNTING 


r  3.jThe  trial  balance  of  a  business  on  Dec.  31  is  as  follows: 


Notes  Receivable 

Notes  Payable 

Accounts  Payable 

Commission 

Wages 

Real  Estate 

Merchandise 

Rent 

Interest 

Royalties 

Proprietor 


90,000 


17,000 

45,000 

50,000 

7,000 


209,000 


20,000 
13,900 
17,000 


100 

S,ooo 
153,000 

209,000 


The  real  estate  has  depreciated  to  $44,000;  the  inventory  of  mer- 
chandise is  $75,000;  $800  worth  of  royalties  have  accrued  in  favor  of 
the  business;  rent  has  accrued  against  it,  $1,000;  interest  has  accrued 
against  it,  $60. 

From  the  information  given  construct  a  six-column  statement. 
Construct  the  ledger  incorporating  totals  and  balances  of  all  accounts 
shown  on  the  six-column  statement  below,  and  close  it.    In  closing  use 
the  clirect  ledger  method.     From  the  ledger  draw  up  a  balance  sheet. 
How^does  it  compare  with  the  resource  and  liability  columns  below? 


Dr. 

Cr. 

Resource 

Liability 

Loss 

Gain, 

Cash 

25,000 

20,000 

5,000 

Mdse. 

90,000 

8o,oco 

57,000 

47,000 

Accounts  Receivable 

122,000 

100,000 

22,000 

Accounts  Payable 

70,000 

74,000 

4,000 

Real  Estate 

36,000 

3,000 

33,000 

Fixtures 

8,000 

1,000 

7,000 

Depreciation 

4,000 

4,000 

Expense 

23,500 

Soo 

300 

22,700 

Interest 

1,000 

200 

800 

Commission 

100 

1,100 

100 

900 

Capital  Stock 

100,000 

100,000 

379,600 

379,600 

124,500 
104,100 

104,100 

27,500 

47,900 

27,500 

Net  Profit 

20,400 

20,400 

5.  The  following  accounts  are  on  the  ledger  of  a  business. 


Cash 

105,500    III 

[p.  9 
100,000 

Interest 
700    111 

[p.  14 
200 

Capital  Stock 
111 

[p.  10 
50,000 

[Commission 
1,700    111 

[p.  IS 
2,400 

THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  233 


Mdse. 
67,000    III 

[p.  II 
50,000 

Real  Estate 
20,000    III 

[p.  16 

Expense 
8,300    III 

[p.  13 
300 

Rent 

III 

[p.  18 
300 

Using  the  information  to*  follow,  close  the  ledger  directly,  without 
the  use  of  journal  entries. 

There  is  an  accrued  interest  liability  of  $100;  of  the  credit  to  rent, 
$200  is  prepaid;  real  estate  has  depreciated  $500;  the  merchandise  in- 
ventory is  $35,000;  $1,200  worth  of  expenses  are  unconsumed;  we  have 
accrued  in  our  favor  $250  for  commission. 

6.  The  following  ledger  balances  are  on  consecutive  pages  (beginning  with 
page  i)  of  the  ledger.  Sales,  $145,000;  Returned  Sales,  $20,000;  Mdse. 
Inventory  1/1/20,  $40,000;  Purchases,  $130,000;  Returned  Purchases, 
$10,000.  The  inventory  of  merchandise  at  closing,  1/1/21,  is  $50,000. 
Enter  the  closing  inventory  of  merchandise  on  the  books,  and  close  the 
ledger  balances  directly  on  the  ledger  to  the  clearing  account.  Carry 
the  final  profit  to  Loss  and  Gain. 

7.  (a)  If  a  controlling  account  is  kept  for  general  expenses  which  are  ad- 

justed at  the  end  of  the  fiscal  period,  how  does  the  controlling  ac- 
count at  that  time  become  adjusted  to  the  facts, 
(b)  The  balance  of  General  Expenses  on  the  general  ledger  is  $7,578. 
The  balances  on  the  accounts  of  the  expense  ledger  are  as  follows: 
Wages,  $5,000;  Insurance,  $248;  Taxes,  $500;  Interest,  $45;  Rent, 
$250;  Telephone  &  Telegraph,  $120;  Light,  $312;  Heat,  $488;  De- 
preciation, $200;  SuppHes,  $140;  Postage,  $275.  At  the  end  of  the 
fiscal  period  inventories  are  as  follows:  insurance,  $200;  rent,  $50; 
supplies,  $70;  postage,  $75.  LiabiHties  not  yet  on  the  books  are: 
wages,  $220;  taxes,  $75;  interest,  $20.  Transfer  all  expenses  of  the 
period  by  journal  entry  to  Goods-in-Process  on  the  general  ledger, 
and  show  both  general  and  subordinate  ledger  for  these  items. 

8.  Enter  the  following  transactions  (which  are  identical  with  those  of 
problem  i,  chapter  XI)  in  the  appropriate  labor-saving  books,  with  con- 
trolling accounts,  and  post  to  the  appropriate  ledgers.  Carry  all  ex- 
pense items  to  a  single  expense  account. 

The  proprietor  invests  $15,000  worth  of  merchandise  and  $5,000  in 
cash. 

Rent  is  paid,  $200;  postage,  $120;  stationery,  $50. 

Goods  are  sold  to  Bay,  $1,000;  Gay,  $800;  Way,  $2,000;  to  cash 
customers,  $1,500. 

Wages  are  paid,  $200. 

Cash  is  received  from  Bay,  $1,000;  Gay,  $800;  Way,  $1,000. 

The  proprietor  withdraws  $100  for  his  personal  use. 

The  inventory  of  merchandise  is  now  found  to  be  $12,000;  the  expense 
inventory  is  found  to  be  $200;  and  an  expense  liabihty  amounts  to  $50. 
Record  these  conditions  by  journal  entries,  adjust  the  books  for  the 
balance  sheet,  and  show  the  balance  sheet. 


234  THE  FUNDAMENTALS  OF  ACCOUNTING 

9.  Show  six  complete  entries,  under  the  six-account  treatment  of  interest, 
of  which  each  debit  expresses  the  same  condition  as  the  corresponding 
debit  to  the  single  account  for  interest  described  in  the  first  half  of 
the  paragraph  entitled  "A  Single  Account  for  Interest"  on  page  210. 
Show  six  corresponding  entries  of  which  each  credit  expresses  the  same 
condition  as  the  corresponding  credit  to  the  single  accoimt. 
10.  The  following  transactions  are  to  be  entered  in  complete  form,  with 
full  details  and  index  references;  the  resulting  figures  are_ta^  carried 
through  a  ten-cdimn.Statement;  the  books  are  then  to  be  closed  as  for 
the  end  of  a  year,  and  a  balance  sheet  for  the  beginning  of  the  new 
period  is  to  be  shown. 

Walter  Dickens  and  Charles  Scott  form  a  three-year  partnership 
under  the  name  of  Dickens  &  Scott.  Under  the  terms  of  the  partner- 
ship agreement  the  profits  and  losses  are  to  be  shared  as  follows: 
Dickens  one-third  and  Scott  two-thirds. 

The  books  to  be  used  are  a  journal,  a  special-column  cash  book, 
a  sales  book,  a  purchase  book,  a-youchcr  register  (not  used  for  mer- 
chandise or  for  wages),  a  sales  ledger,  a  purchase  ledger,  and  a  general 
ledger.  Six  per  ce^t.  should  be  usedfor  interest  ^p(]  disf^ount.  At  the 
end  of  thfe  period,  the  inventory  of  merchandise  is  $44,900;  of  stationery, 
fi^oj^of  wrapping  supplies,  $100.  Depreciation  of  store  equipment  is 
$20;  accrued  taxes  are  $75.  In  determining  and  recording  profits,  care 
should  be  taken  that  all  necessary  additional  facts  are  considered. 

January  i.  Dickens  invests  $20,000  in  cash.  Scott  invests:  $5,000 
in  cash;  store  equipment  worth  $2,000;  a  note  of  G.  Stone  for  $3,000, 
payable  March  i,  with  interest;  a  note  of  O.  HoImes'!or  $5,000,  due 
January  16,  without  interest;  a  note  ofR.  Wood  for  $5jO0to,  due  Feb- 
ruary I,  with  interest."  All  notes  have  run  since  December  i. 

January  2.  A  store  isMeased  for  two  years  and  rent  is  paid  for 
three  months,  $450.  The  business  buys  on  account  from  Brownlee 
Bros.  $  1 0,000  worth  of  merchandise;  for  payment  in  10  days  6%  dis- 
count is  offered.  Office  fumitiure  is  bought  on  account  from  Empire 
Desk  Co.,  $500. 

January  3.  Buy  merchandise  from  Briggs  &  Son,  $5,oooJ  Buy 
stationery  from  Watermark  Co.  for  cash,  $200.  Two  salesgirls  are  hired 
at  $15  per  week. 

January  4.  Scott  withdraws  $100  to  pay  his  personal  bills.  Sell 
merchandise  on  accoimt:  H.  Henry,  $2,000;  W.  Whitman,  $3,000;  S. 
Foss,  $5,000.  Foss^ii^fiS-a  note  for  his  merchandise,  payable  March  5 
without  interest  —  the  bill  is  due  on  that  day. 

January  8.  Buy  merchandise,  $10,000,  from  Brownlee  Brothers, 
subject  to  6%  discount  for  payment  in  ten  days.  Pay  salesgirls' 
wages,  $20,  for  previous  week's  services. 

January  9.  Pay  Brownlee's  bill  of  January  2,  taking  advantage  of 
the  discount. 

January  10.  Discoimt  Foss's  note  at  the  bank.  Pay  $100  for 
freight  on  merchandise  received.    Buy  store  sign,  $50.    Sell  R.  Wood- 


THE  TECHNIQUE  OF  CLOSING  THE  BOOKS  235 

worth  merchandise  on  account,  $4,000.  Sell  merchandise  for  cash, 
$100.    H.  Henry  pays  his  bill. 

January  11.  Buy  merchandise  on  account  from  Pope  Bros.,  $3,000. 
Sell  Henry  merchandise,  $10,000,  and  receive  in  part  payment  cash, 
$5,000. 

January  15.  Pay  wages  as  agreed.  Pay  insurance,  $75  for  a  one- 
year  policy  covering  merchandise,  and  $250  for  a  three^^ear  policy  cover- 
ing the  lives  of  the  partners  in  accordance  with  tne  partnership  agree- 
ment. Give  merchandise,  cost  price  $75,  sales  price  $100,  to  pay  for 
advertising  at  a  Bazaar.  Whitman  and  Woodwofth  pay  their  bills. 
Holmes  pays  his  note. 

January  20.  Pay  Brownlee's  bill  of  January  8,  and  pay  Pope  Bros. 
$2,000  on  account.     Pay  Empire  Desk  Co. 

January  22.  Pay  a  commission  of  $278  to  salesmen  seUing  on  com- 
mission, and  $200  for  remodeUng  the  store.  Pay  wages  as  agreed. 
Buy  at  a  bankruptcy  auction  the  stock  of  Long  Brothers  for  $50,000, 
paying  $10,000  in  cash,  the  balance  to  be  paid  in  four  equal  monthly 
jnglallments  due  on  the  15  th  of  each  month. 

January  29.  Pay  wages  as  agreed.  Buy  reference  books  on  accotmt, 
Corner  Book  Store,  $50. 

February  2.  Interest  $4.10  is  shown  as  earned  by  the  bank  state- 
ment. $15  disappears  from  the  cash  drawer.  Whitman  buys  $12,000 
worth  of  merchandise  on  account.  Sell  Foss  merchandise  on  account, 
$3,000.  Wood's  note  is  paid.  Wrapping  paper  and  twine  are  bought 
from  Fordyce  &  Company,  on  account,  $170,  terms  6%  in  ten  days. 

February  5.    Pay  wages  as  agreed. 

February  7.  Pay  Fordyce  &  Company.  In  preparation  for  payment 
to  Long  on  the  15th  we  draw  a  draft  on  Whitman,  for  $10,000,  pay- 
able  February  15  (the  day  on  which  Whitman's  bill  is  due)  without  in- 
terest. Whitman  accepts  the  draft. 

February  10.  The  books  are  closed  preparatory  to  admitting  a  third 
partner  to  the  business. 


CHAPTER  XV 

AUXILIARY  RECORDS 

Tjrpes  of  Auxiliary  Record.  Much  information  expressible  in 
figures  and  in  tabular  form  is  of  importance  in  connection  with 
bookkeeping  records,  even  though  it  does  not  get  recorded  in 
debits  and  credits.  Some  of  this  consists  of  details  applicable 
directly  to  debit  and  credit  items,  such  as  the  classification  of 
accounts  receivable  by  date  of  required  payment,  and  some  has 
no  such  direct  application  but  constitutes  parallel  information, 
such  as  number  of  sales  made,  number  of  articles  manufactured, 
number  of  tons  of  fuel  burned.  Let  us  examine  first  the  book- 
keeper's records. 

The  Use  of  Petty  Cash.  In  most  businesses  many  kinds  of  ex- 
penditure are  frequent  but  small  in  amount.  The  books  would 
be  unnecessarily  burdened  if  each  expenditure  of  this  sort  were 
given  full  bookkeeping  recognition.  Such  items,  moreover,  be- 
ing small,  require  less  formality  of  vouching  than  normal  items. 
Usually,  therefore,  some  one  is  designated  to  keep  a  petty  supply 
of  cash  for  such  expenditures,  and  to  keep  the  ''petty  cash  ac- 
count." One  convenient  method  of  handling  this  account  is  to 
debit  Petty  Cash  through  the  cash  book  whenever  funds  are 
given  to  the  cashier  of  petty  cash,  and  then,  through  the  journal 
at  convenient  intervals,  distribute  as  debits  to  the  various  ex- 
pense accounts  the  total  amount  spent  for  each  since  the  last 
distribution,  with  a  credit  to  Petty  Cash.  This  leaves  as  a  bal- 
ance on  Petty  Cash  at  all  times  the  sum  of  the  petty  cash  in 
hand  and  the  amount  spent  since  the  last  distributing  journal 
entry  —  ready  for  the  next.  Many  other  methods  have  been 
used,  but  that  most  widely  recommended  is  called  the  "impressed 
system."  Any  one  who  understands  this  can  easily  understand 
the  others  when  he  has  examined  them,  and  hence  here,  as  we 
are  not  attempting  to  treat  completely  all  sorts  of  bookkeeping 
method,  we  will  illustrate  this  only. 

The  Impressed  System  of  Petty  Cash.     The  theory  of  this 


AUXILIARY  RECORDS 


237 


system  is  that  when  the  cashier  of  petty  cash  finds  the  cash  near- 
ing  exhaustion  he  makes  a  demand  upon  the  general  cashier  for 
replenishment  of  the  exact  amount  already  disbursed.  He  "im- 
presses" more  cash.  He  has  kept  a  record  of  all  cash  spent  (in 
simple  memorandum  form,  or  in  simple  cash-book  form) ,  and  at 
the  time  of  impressment  of  more  cash  notifies  the  general  cashier 
for  what  the  money  to  be  replaced  has  been  spent.  The  general 
cashier  then  draws  a  check  for  the  exact  amount,  and  debits  the 
replenishment  to  the  accounts  for  which  the  original  money  was 
spent.  He  then  has  a  cancelled  check  as  his  voucher  for  this  ex- 
penditure. So  the  petty  expenditures  are  entered  on  the  general 
books  in  summarized  form  (all  items  of  a  kind  combined  in  the 
report  requisitioning  more  money),  but  are  entered  late  because 
of  the  fact  that  they  are  entered  at  the  time  of  replacement  rather 
tlian  of  original  pa3nnent.  In  case  of  need  of  reference  to  the 
actual  pa)anent,  of  course,  the  petty  cash  account  is  consulted. 
The  process  is  repeated  as  often  as  replenishment  becomes  nec- 
essary. Except  for  the  initial  entry  when  the  petty  cash  fund  is 
first  established,  this  is  all  there  is  of  the  system.  The  initial 
entry  simply  debits  Petty  Cash  and  credits  Cash.  No  other 
entries  are  ever  necessary  for  Petty  Cash  unless  the  size  of  the 
maximum  fund  is  increased  or  reduced.  Petty  Cash  represents 
a  subdivision  of  general  cash  —  the  cash  held  by  a  special  cashier; 
and  of  course  the  cashier  of  petty  cash  must  at  all  times  have  on 
hand  either  cash  or  vouchers  for  the  full  amount  of  the  petty-cash 
fund;  and  at  the  close  of  the  fiscal  period  he  will  take  pains  to  get 
replenishment  and  so  have  actual  cash  as  called  for  by  the  bal- 
ance sheet,  and  thus  the  general  books  will  have  record  of  petty 
cash  expenditures  for  the  period.  The  whole  process  is  illustrated 
below,  on  the  supposition  that  the  general  cash  book  already  has 
several  convenient  special  columns. 


GENERAL  CASH  BOOK 
DishursemetUs 


Jan.    I  isS 
15  K 

|36 


Petty  Cash 

Sundries 

Freight  &  Cartage 


To  establish,  #878 

Petty  Cash  replenished,  #910 


Wages 

i 

Travel 
Exp. 

I  Post- 

1     age 

SuH4r. 

1 

so 

00 

6 

1 

14 

00 

17 

00 

3 

00 

238 


THE  FUNDAMENTALS  OF  ACCOUNTING 


PETTY  CASH  BOOK 


Receipts 
Jan.    I  Received  check  #878 


SO 

00 

Jan.  3 

8 

xo 
14 

"50 

00" 

"lO 

00 

40 

00 

3 

IS 

il 

6 

18 

8s 

IS 

17 

6 

00 

7 

3a 

I 

29 

40 

00 

JO 

00 

50 

00 

Disbursements 
Express  —  Plans 
Car  fares  —  W.  J.  M. 
Postage  —  Parcel  Post 
Travel  —  L.  M.  H.  —  Hanulton 
Express  —  Ink 
Postage  —  Stamps 
Wages  —  A.  H.  J.  —  Sunday 
Travel  —  R.  F.  P.  —  Groton 
Postage  —  Cards 

Summary 
Wages  6.00 

Travel  14.00 

Postage  17.00 

Frt.  &  Cart.  3  00        40.00 

Balance 


Balance 

Replenishment  check,  #910 

Note  Book,  or  Bill  Book.  When  notes  receivable  and  notes 
payable  are  handled,  it  is  important  to  have  adequate  reminders 
when  they  are  due.  If  one  is  not  prepared  to  pay  notes  payable 
and  accepted  drafts  as  they  mature,  one's  credit  is  seriously  im- 
paired and  business  thereafter  will  be  conducted  imder  a  handi- 
cap. If  one  does  not  present  notes  receivable  and  accepted 
drafts  for  payment  when  due,  one  loses  the  use  of  the  money,  and, 
what  is  often  far  more  serious,  any  endorsers  on  the  notes  and 
drafts  are  released  from  their  liability  to  pay  in  case  the  makers 
or  drawees  refuse  or  are  unable  to  pay.  A  common  form  of  book 
for  notes  and  drafts  contains  full  information  about  each,  show- 
ing receivable  and  payable  items  separately  (commonly  at  op- 
posite ends  of  the  book),  and  giving  each  note  and  draft  a  mmiber. 
Then  entries  may  refer  to  them  by  number,  as  N.  R.  (Note  Re- 
ceivable) #249,  N.  P.  #121,  and  avoid  detailed  explanation.  A 
line  is  given  for  each  note  or  draft,  and  columns  are  provided  for 
the  date  of  entry,  number  of  note  or  draft,  maker  pf  note  or 
drawee  (payer)  of  draft,  endorsers  of  notes  or  drawer  and  en- 
dorsers of  drafts,  date  of  note  or  draft,  terms  of  payment,  and 
date  due.  As  a  ready  reminder  of  the  day  for  payment,  a  column 
is  provided  for  each  month  in  the  year,  and  opposite  each  note  is 
given  in  the  column  for  the  appropriate  month  the  day  on  which 
it  is  due.  When  many  notes  are  handled,  several  columns  for 
day  due  are  provided  for  each  month,  as  i-io,  11-20,  21-31,  or 
1-8,  9-16,  17-24,  25-31.    Thus  a  glance  daily  down  the  appro- 


AUXILIARY  RECORDS  239 

priate  column  shows  whether  provision  must  be  made  at  once  for 
any  item. 
Accounts-Receivable  Book  and  Accounts-Payable  Book.    Not 

only  in  most  businesses  in  which  capital  is  not  overabundant,  but 
also  in  businesses  with  abundant  capital,  it  is  desirable  to  make 
the  fullest  use  of  all  capital  available.  Capital  not  needed  for  the 
main  enterprise  of  the  business  should  be  utilized  in  side  lines,  or 
should  be  invested  outside;  and  capital  set  free  during  the  dull 
periods  of  a  seasonal  business  should  be  apph'ed  temporarily  to 
some  enterprise.  This  means  a  reasonably  close  margin  of  free 
cash  at  all  times:  and  that  means,  in  turn,  watching  payments 
and  payables  and  collections  and  collectibles,  so  that  cash  may  be 
available  when  needed  and  not  be  lying  idle  when  not  needed. 
One  should  know  what  cash  should  be  coming  in  during  any 
month,  and  what  bills  should  be  paid.  This  is  provided  for  by 
forms  which  distribute  accounts  receivable  and  accounts  payable 
over  months  as  soon  as  they  are  entered  in  the  books  of  original 
entry.  The  sales  book  itself,  for  example,  may  be  provided  with 
such  columns,  in  which  case  it  may  well  be  called  an  "accounts- 
receivable  book."  In  businesses  in  which  discounts  are  given  for 
early  payment  of  bills,  payments  are  likely  to  be  made  earher 
than  the  maturity  day,  and  then  care  must  be  taken  to  see  that 
items  paid  early  do  not  remain,  as  if  collectible,  in  the  column  for 
the  later  date.  This  is  easily  accomplished  by  cancelling  the 
amounts  of  such  bills  in  the  columns  for  due  days  and  entering 
them  in  the  columns  for  the  months  when  paid.  If  any  items  are 
not  paid  either  in  the  months  when  due  or  earlier,  they  are  cancelled 
and  carried  forward  to  the  subsequent  months.  When  discounts 
are  taken,  they  also  may  be  entered  in  this  book,  for  completeness  of 
record.  Then  the  total  of  the  amounts  shown  as  collectible  in  any 
month  and  not  cancelled,  plus  the  amounts  brought  in  from  other 
months  as  paid  early  or  late,  shows  the  collections  of  the  month 
and  should  agree  with  the  cash-book  collections  for  the  month. 
The  total  discounts  for  early  payment  reported  here  should  also 
agree  with  the  discounts  shown  on  the  cash  book.  Sometimes  this 
accounts-receivable  book  is  substituted  for  the  accounts-receivable 
ledger,  in  which  case  Accounts  Receivable  is  not  a  controlling  ac- 
count, of  course.    One  form  of  accounts-receivable  book  follows. 


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AUXILIARY  RECORDS  24I 

It  will  be  noted  that  posting  is  made  from  the  first  "amount" 
column,  but  not  from  later  colunms.  They  are  statistical  only. 
Bill  #621  though  entered  as  due  in  March  was  paid  in  January; 
#622  was  similarly  paid,  but  twenty  days  later;  #623  is  still  due, 
in  February;  #624,  though  due  in  January,  still  remains  unpaid. 
Bills  paid  early  require  no  *'  due  "  notation  in  the  transfer  month; 
but  bills  overdue  should  have  a  blanket  date  in  the  later  month. 
The  footings  for  January  are  taken,  for  they  should  check  with 
the  corresponding  items  of  the  cash  book.  Those  for  February 
and  March  are  not  yet  taken,  for  other  items  will  be  added  later. 
Of  course  the  accoimts-payable  book  can  be  similarly  treated. 

Ticklers.  When  many  notes  are  handled,  or  many  accounts 
are  to  be  collected  or  paid,  it  may  pay  to  have  a  book  devoted  ex- 
clusively to  "tickling"  the  memory  of  the  person  responsible  for 
their  presentation  or  payment,  and  providing  a  space  for  each 
business  day  of  the  year.  This  space  then  is  preferably  a  block 
rather  than  a  column,  with  all  items  due  that  day  and  nothing  else 
in  that  block,  and  contains  all  the  information  necessary  to  iden- 
tify the  item  and  prepare  for  its  care.  A  bank  making  collections 
for  others  must  be  particularly  careful  not  to  neglect  its  responsi- 
bility.   A  tickler  might  look  as  follows: 

Jtdy  12 

Num-  For  Whom 

her          Payer  Endorser  Where  Payable  Amount          Collected      Pd.  Cr.  Remarks 

783     A.  Browne    C.  Davis       Canal  National     753.10    E.  French 

815    G.  Henry      I.  Jacobs      63  Congress  St.   618.18    K.  Lincoln 

Check  marks  will  show  that  the  items  have  been  collected,  and 
that  they  have  been  credited  to  those  for  whom  they  were  col- 
lected, when  such  marks  are  appropriate. 

Other  Au3dliary  Records.  Records  of  the  sort  now  to  be  dis- 
cussed are  not  standard  and  universal,  for  they  differ  with  the 
type  of  business,  and  among  businesses  of  the  same  type  they  differ 
with  the  circumstances.  They  constitute  what  are  commonly 
called  statistics,  and  differ  from  the  statistics  already  discussed 
in  that  either  they  are  not  expressible  in  dollars  and  cents,  or  they 
are  not  expressed  in  terms  of  debit  and  credit,  even  though  expres- 
sible in  dollars  and  cents.  They  are  required  for  intelligent  in- 
terpretation of  the  debit  and  credit  figures.  Problem  3  of  Chap- 
ter VI,  page  67,  is  a  good  illustration.    To  know  what  you  pay 


[2  THE  FUNDAMENTALS  OF  ACCOUNTING 

r  a  thing  is  not  very  enlightening  unless  you  know  just  what 
e  thing  is  that  you  get.  Many  business  realities  are  too  com- 
ex  to  be  clearly  expressed  by  a  simple,  or  even  a  complex,  term, 
ley  must  be  analyzed  and  expressed  in  figures,  or  even  in  com- 
exes  of  many  kinds  of  figures  at  once.  This  is  true  not  only  of 
irchases,  but  of  expenses  (like  wages,  insurance,  and  rent),  of 
oduction,  and  of  sales;  and  many  of  these  hinge  upon  chains 
earlier  statistics,  which  in  turn  hinge  upon  others.  A  few  only 
these  can  be  given  here,  but  they  suggest  the  kind  of  thing 
at  good  accounting  requires  —  for  the  task  of  the  accountant 
to  analyze  and  interpret  a  business. 

Statistics  of  Purchases.  Suppose  a  shoe  dealer  finds  during  a 
oe  season  that  he  is  continually  losing  an  opportunity  to  make 
sale  because  though  he  can  suit  his  customer  in  style  and  qual- 
r  and  price  he  has  not  shoes  that  fit.  What  is  his  remedy  for  the 
ture?  Clearly  next  season  to  change  the  sizes  on  his  purchase 
ders.  But  how?  Unless  he  knows  what  he  ordered  for  this 
ason,  and  what  sizes  he  failed  to  provide,  he  is  quite  as  likely 
go  wrong  again  next  season.  Suppose  a  manufacturer  of 
oes  finds  that  certain  lots  of  leather  when  cut  for  shoes  have 
uch  waste  because  of  small  scraps,  or  are  of  poor  quality,  or  are 
varying  quality.  What  is  his  remedy  for  the  future?  Unless 
;  has  records  which  show  where  the  particular  lots  came  from, 
what  sorts  of  leather  they  actually  contained,  he  cannot  pro- 
ed  more  intelligently  next  year.  He  cannot  tell  what  sorts  not 
buy,  nor  of  whom  not  to  buy,  nor  can  he  be  even  sure  whether 
e  waste  was  due  to  poor  shapes  of  skins  or  to  careless  cutting 
L  the  part  of  his  cutters.  Suppose  a  manufacturing  chemist 
lys  raw  material  in  many  markets,  and  finds  that  some  days  he 
its  ten  hundredweight  of  a  certain  product  from  a  ton  of  raw 
aterial,  and  on  other  days  he  gets  only  nine  hundredweight,  and 
I  some  eleven.  Wliat  is  his  procedure  to  get  eleven  hundred- 
eight,  or  to  learn  whether  nine,  ten,  or  eleven,  is  most  profitable 
r  him?  So  many  different  elements  enter  into  the  cost  that 
^en  though  he  finds  that  it  costs  more  in  proportion  to  produce 
even  himdredweight  than  nine,  it  may  still  pay  to  go  on  doing 
ime  of  the  things  that  enter  into  the  higher  cost,  for  they  may 
)t  be  the  elements  that  cause  the  higher  cost.    In  other  words, 


AUXILIARY  RECORDS  243 

to  say  that  a  thing  costs  more  is  not  to  say  that  everything  done 
for  that  thing  is  unwise.  The  question  is,  What  makes  it  cost 
more?  Perhaps  the  raw  material  contains  more  moisture,  so 
that  a  ton  has  more  worthless  water  that  goes  off  in  steam.  Per- 
haps more  impurities  go  to  make  up  the  weight.  Only  statistics 
of  the  content  of  raw  material  purchased  will  tell  him.  Perhaps 
the  chemical  processes  are  not  carried  far  enough,  and  not  all  the 
valuable  constituents  of  the  raw  material  are  extracted.  Only 
statistics  of  original  content  compared  with  final  yield  will  show 
whether  the  waste  is  excessive.  Perhaps  the  raw  material  is  re- 
fractory, and  extended  treatment,  involving  more  hours  of  labor 
and  power,  is  necessary  to  extract  the  proper  amount.  Only  sta- 
tistics will  show  that  this  material  is  not  adapted  to  the  need. 

Statistics  of  Expenses.  Suppose  a  merchant  finds  that  be- 
tween two  stores  that  he  manages,  with  the  same  line  of  goods 
and  the  same  sort  of  clientele,  one  has  a  wages  cost  of  $20,000 
with  $100,000  of  sales,  and  the  other  a  cost  of  $22,500  with 
$150,000  of  sales.  What  can  he  do  about  it?  There  must  be  a 
reason  for  this  difference.  Several  possible  reasons  suggest  them- 
selves. First  we  note  that  it  costs  in  one  store  twenty  cents  for 
wages  to  sell  a  dollar's  worth  of  goods,  and  in  the  other  fifteen. 
There  may  be  too  many  clerks  for  the  volume  of  business;  the 
clerks  may  spend  too  much  time  chatting  with  customers,  and 
therefore  serve  a  smaller  number  of  customers  each;  the  individ- 
ual sales  may  run  smaller  with  the  same  amount  of  attention 
given  by  the  salesmen;  the  salesmen  may  too  readily  induce  cus- 
tomers to  take  goods  on  trial  and  thus  incur  too  many  returned 
sales,  forgetting  that  it  takes  almost  as  long  to  sell  an  article  that 
comes  back  as  one  that  stays  sold.  Only  statistics  will  show 
which  of  these  various  suppositions  is  true.  Very  likely  some  of 
the  clerks  are  shirkers  and  they  bring  down  the  average.  Statis- 
tics of  indi\ddual  sales  will  detect  this.  Suppose  the  dehvery 
charge  for  one  year  is  much  higher  than  in  another,  not  only  in 
total  but  per  dollar  of  sales.  The  explanation  may  be  higher 
delivery  wages,  longer  distances  for  delivery,  more  frequent  de- 
liveries or  deliveries  of  smaller  orders,  increase  in  C.O.D.  orders, 
slower  rate  of  travel,  or  dawdling.  How  shall  one  tell?  Statistics 
can  give  number  of  deliveries,  mileage,  average  size  of  deliveries, 


244  THE  FUNDAMENTALS  OF  ACCOUNTING 

number  of  different  places  visited,  number  of  C.O.D.  orders, 
average  rate  of  travel,  etc. 

Statistics  of  Production.  In  manufacturing  businesses  the 
common  standard  of  statistical  comparison  is  production.  If 
purchases  and  expenses  go  up  or  down,  they  should  go  in  a  recog- 
nizable relation  (not  necessarily  in  the  same  proportion,  as  we 
shall  see  in  the  chapter  on  finding  costs),  and  hence  statistics  of 
production  are  essential  to  adequate  comparative  studies;  but  the 
dollar  of  value  produced  is  not  always  adequate  as  a  standard  of 
comparison,  for  both  more  productive  service  and  more  profit  may 
sometimes  come  from  product  with  a  low  selling  price  than  from 
product  with  a  high  price.  A  greater  service  may  be  rendered  to 
the  community  by  producing  $120,000  worth  of  one  kind  of  goods 
at  a  cost  of  $100,000  than  by  producing  $240,000  worth  of  an- 
other at  a  cost  of  $225,000,  and  it  would  pay  the  proprietor  to 
make  the  lower  cost  goods,  for  he  gets  a  larger  margin  of  profit, 
and  even  more  wages  and  more  employment  for  factory  facilities 
may  be  provided  —  for  the  cost  of  raw  material  may  be  so  much 
higher  in  the  second  case  than  in  the  first  as  to  make  all  the  differ- 
ence in  selling  price.  Clearly  here  neither  costs  nor  profits  can  be 
put  on  a  dollar  basis  of  comparison.  Comparisons  must  be  made 
on  a  unit  of  productivity  other  than  dollars,  and  that  unit  must 
take  into  account  the  difference  in  the  nature  of  the  products. 
This  is  no  place  to  establish  standards  of  comparison  for  varying 
products;  sufficient  here  is  it  to  point  out  that  such  standards  can 
be  established  and  comparisons  can  be  made  only  through  statis- 
tical analysis  of  the  situation.  They  would  involve,  to  give  only 
a  few  illustrations,  such  things  as  horse-power  consumption,  labor 
hours,  machine  hours,  and  idle  hours  of  machinery. 

Statistics  of  Sales.  Sales  statistics  have  already  been  discussed 
somewhat  in  connection  with  those  of  purchases  and  expenses. 
Usually  they  are  used  as  a  basis  for  making  a  comparative  study 
of  the  others.  A  few,  however,  are  more  or  less  independent. 
The  most  interesting  of  these  is  stock- turn.  How  many  times  a 
year  is  the  stock  of  goods  sold  out  and  replenished?  If  a  man  can 
sell  his  stock  of  goods  and  replenish  it  six  times  a  year,  he  needs, 
so  far  as  stock  is  concerned,  only  one-sixth  as  much  capital  as  the 
man  who  can  sell  his  stock  only  once  a  year;  in  other  words,  the 


AUXILIARY  RECORDS  245 

man  who  can  run  a  store  successfully  on  a  two  months'  supply  of 
goods  has  only  one-sixth  as  much  money  tied  up  as  the  man  who 
requires  a  year's  supply.  Statistics  of  stock-turn  are  therefore 
very  important. 

Other  Statistics.  Many  other  items  not  directly  connected 
with  any  so  far  mentioned  are  worthy  of  careful  study.  Much 
attention  in  large  establishments  should  be  given  to  what  is  com- 
monly called  "labor-turnover."  How  many  employees  are  em- 
ployed in  a  year,  on  the  average,  to  keep  one  position  filled?  If 
the  business  has  2,000  positions,  and  4,000  different  persons  were 
employed  to  fill  those  positions  in  any  year,  the  labor-turnover  in 
that  year  was  two.  This  is  typical  of  the  use  of  statistics  not  only 
non-financial,  but  not  directly  connected  with  any  financial  fig- 
ures. Many  businesses,  from  such  figures  as  these,  moreover, 
have  learned  how  much  it  costs  them,  on  the  average,  to  change 
employees. 

Methods  of  Gathering  Statistics.  Many  of  the  figures  men- 
tioned involve  special  devices  or  special  records.  Many,  on  the 
other  hand,  can  be  gathered  by  the  utilization  of  devices  already 
provided  for  bookkeeping  purposes  merely  by  the  addition  of  a 
colimm  or  two  and  an  additional  item  for  each  entry.  The  nirai- 
ber  of  sales  made  is  easily  got  by  mmibering  sales  consecutively 
and  using  the  number  on  the  sales  book  —  an  automatic  number- 
ing machine  can  be  operated  by  an  inexpensive  clerk  or  office 
boy.  Individual  clerk's  sales  are  easily  entered  from  sales  slips. 
The  railroads  find  passenger-miles  (nimiber  of  passengers  multi- 
plied by  the  number  of  miles  traveled  by  each)  by  multiplying 
the  number  of  tickets  sold  between  each  two  stations  (reported 
necessarily  by  ticket  agents  for  income  purposes)  by  the  number 
of  miles  between  the  stations  named.  Ton-miles  (number  of 
tons  multiplied  by  number  of  miles  hauled)  are  got  similarly 
from  necessary  freight  reports.  The  number  of  train  miles  is 
got  from  necessary  conductors'  reports. 

Advantages  of  Putting  Statistics  on  the  Ledger.  One  of  the 
advantages  of  double  entry  is  the  test  by  the  trial  balance,  which, 
as  we  have  seen,  does  not  prove  that  figures  are  right  but  does 
give  very  good  presumptive  evidence  that  they  are  right.  If 
statistics  have  no  check  against  error,  they  are  less  valuable  than 


246  THE  FUNDAMENTALS  OF  ACCOUNTING 

if  well  supported  by  presumptive  evidence.  It  is  possible  to  run 
through  the  books  of  original  entry  and  the  ledger  any  statistical 
figures  that  are  expressible  in  dollars  and  cents,  for  it  is  possible  to 
express  a  double  aspect  of  such  figures  and  thus  to  put  them  into 
double  entry  and  subject  them  to  the  trial-balance  test  of  correct- 
ness. 

Statistical  Accounts  in  Municipal  Administration.  A  good  il- 
lustration of  this  is  in  municipal  accounting,  in  which  it  is  neces- 
sary to  keep  track  of  appropriations,  of  commitments  against 
appropriations,  and  of  expenditures  against  appropriations.  Yet 
some  of  these  do  not  constitute  transactions  normally  expressed 
in  debit  and  credit  entries.  Indeed,  when  the  municipal  depart- 
ment does  not  handle  funds  directly  but  handles  its  finances 
through  the  city  treasurer,  it  has  no  transactions  in  the  ordinary 
sense,  but  it  does  need  statistics  of  its  operations.  It  may  keep 
statistical  accounts  by  ordinary  bookkeeping  methods,  though  of 
course  it  will  use  titles  for  its  accounts  differing  from  ordinary 
commercial  titles.  It  wishes  a  record  of  money  appropriated  by 
the  city  government  for  its  use,  and  it  wishes  a  record  of  any 
amounts  of  expenditure,  or  expenditure  contracted  for,  that  it  has 
already  applied  against  each  appropriation.  It  should  not  be 
dependent  on  the  treasury,  moreover,  for  its  information.  It 
needs  more  information  than  the  treasury  can  give  it,  and  much 
information  it  wishes  in  form  different  from  that  which  the  treas- 
ury uses.  It  may  wisely  therefore  keep  its  own  set  of  books,  using 
titles  different  from  those  of  the  treasury  not  only  because  confu- 
sion should  be  avoided  but  because  the  point  of  view  is  different. 
Having  no  cash  and  no  accounts  receivable,  for  instance,  it  will 
have  no  accounts  for  those  items;  but  it  will  wish  to  know  what 
cash  the  treasury  has  available  for  it  to  draw  upon,  and  what  the 
treasury  is  collecting  for  it  on  bills.  It  will  have  one  or  more  ap- 
propriations, or  authorizations,  to  spend  money.  The  appropria- 
tion is  what  has  been  granted  to  the  department  for  its  purposes, 
and  hence  the  department  will  credit  Appropriation  for  the 
amoimt.  It  will  correspondingly  debit  Appropriation  for  amounts 
chargeable  against  it,  thus  reducing  the  balance  of  appropriation. 
The  balance  of  the  account  is  the  available  appropriation  remain- 
ing for  further  activity.    It  is  clear  that  appropriations  cannot 


AUXILIARY  RECORDS  247 

be  made  out  of  nothing,  however.  The  funds  that  will  supply 
an  appropriation  constitute  the  complement  of  the  appropriation, 
and  consequently  accounts  representing  them  will  be  debited  when 
the  accounts  for  the  appropriations  are  credited.  If  the  funds 
are  expected  to  come  from  revenues  of  the  current  period,  Es- 
timated Revenues  is  debited  (an  asset  account).  When  those 
revenues  become  real,  this  account  is  credited  (for  the  transfer 
of  the  asset  from  one  classification  to  another),  and  a  new  account 
representing  the  new  status  of  the  asset  is  debited  If  the  money 
is  already  in  the  hands  of  the  treasurer,  ready  to  be  drawn  on 
warrants,  the  new  account  may  well  be  Current  Funds.  This 
principle  may  be  carried  through  all  a  department's  transac- 
tions, giving  it  full  information  in  spite  of  the  fact  that  it  has 
no  actual  assets  and  liabilities  independent  of  those  recorded  in 
another  form  on  the  treasurer's  books. 

General  Comment.  Railroads  gather  such  a  multitude  of 
operating  statistics  (for  such  things  as  car  loads,  train  loads,  fuel 
consumption,  cars  switched,  and  rails  replaced),  and  when  these 
are  intelligently  gathered  and  intelligently  used  get  so  much 
light  on  the  success  and  economy  of  operation,  that  it  is  worth 
while  for  one  contemplating  a  system  of  statistics  to  study  rail- 
road reports  and  see  what  sorts  of  thing  the  railroads  use  —  real- 
izing that  they  publish  only  a  very  small  part  of  what  they  use. 
Two  cautions  with  respect  to  statistics  must  be  constantly  borne 
in  mind:  first,  that  figures  gathered  but  not  intelligently  used 
give  no  information  —  they  give  rather  a  dangerous  because  false 
sense  of  security;  second,  that  figures  that  purport  to  be  one  thing 
but  really  are  another  are  dangerous,  for  they  lead  to  baseless  con- 
clusions —  the  figures  must  be  very  carefully  gathered  and  must 
be  so  clearly  labeled  that  they  can  never  be  mistaken  for  what 
they  are  not. 

QUESTIONS  AND  PROBLEMS 

I.  (a)  A  new  bookkeeper  takes  over  the  books  of  a  business.  He  finds 
that  petty  cash  is  debited  $50  on  the  books.  How  should  he  verify 
its  correctness? 
(b)  At  the  end  of  the  month  there  is  $20  in  the  petty -cash  drawer,  and 
vouchers  for  the  balance  indicate  expenditures  as  follows:  Charity 
$2.00,  Cleaning  $15.00,  Postage  $10,00,  Freight  $3.00.  It  is  decided 


248  THE  FUNDAMENTALS  OF  ACCOUNTING 

that  $25  is  a  sufladent  sum  for  the  petty-cash  fund.  What  entries 
should  the  new  bookkeeper  make  m  the  cash  book  for  replenishment 
at  the  new  figure,  provided  there  are  in  the  cash  book  special  columns 
for  Freight  and  Postage. 

2.  A  furniture  store  sells  furniture  to  customers  on  the  basis  of  four  monthly 
installments.  What  kind  of  device  should  you  suggest  for  keeping  track 
of  the  installments? 

3.  An  ice  company,  for  which  a  summary  statement  is  given  below,  wishes 
certain  statistical  information. 

Sales  $300,000 

Ice  on  hand  1/ 1/  20  $    5,000 

Harvesting  Costs  200,000 

Cost  of  ice  handled  $205,000 

Ice  on  hand  12/31/20  20,000 

Cost  of  ice  sold  $185,000 

Delivery  Expenses 

Maintenance  of  Equipment  $20,000 

Wages  of  Teamsters  45, 000 

Administrative  Expenses  35,000                100,000 

Total  cost  285,000 

Profit  $15,000 

Ice  was  sold  for  $.60  a  hundredweight.  An  average  of  40  teamsters 
were  employed.  Deliveries  were  made  300  days  in  the  year.  The 
average  delivery  is  one  hundred  poimds. 

Find  (a)  hundredweight  sold 

(b)  tons  sold 

(c)  deUvery  cost  per  hundredweight 

(d)  average  deUvery  (tons)  per  man  per  year 

(e)  "  "  "        "      "      "  day 

(f)  "  "        (cwt.)    "     "      "  day 

(g)  "       number  of  deliveries  per  man  per  day 
(h)  percentage  of  delivery  cost  to  sales 

(i)         "  "    cost  of  ice  sold  to  sales 

(j)         "  "    administrative  expense  to  sales 

(k)        "  "    profit  to  sales 

(1)  profit  on  average  sale 
If  the  loss  by  melting  of  ice  was  $20,000,  how  should  you  show  this 
loss  on  the  operating  statement? 


CHAPTER  XVI 

SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS 

The  Essential  Nature  of  Corporations.  Many  features  distin- 
guish corporate  from  private  ownership,  but  most  of  them  are 
legal  or  economic  and  have  no  accounting  significance.  Legally  a 
corporation  is  usually  perpetual,  self-continuing,  whereas  a  single 
proprietor's  business  stops  with  his  death,  and  a  partnership  is 
dissolved  with  the  death  or  individual  bankruptcy  of  any  partner 
or  at  the  expiration  of  a  term  of  years.  This  has  accounting  sig- 
nificance because  in  two  of  these  cases  a  death  involves  settling 
the  affairs  of  the  business  and  in  the  other  case  it  does  not.  In  a 
corporation  usually  the  stockholders  have  no  personal  liability 
for  any  debts  of  the  corporation  (beyond  their  investment,  or 
original  required  payment  for  capital  stock),  but  a  single  pro- 
prietor or  a  partner  is  liable  to  the  full  extent  of  his  property  for 
all  the  debts  of  his  firm.  This  has  accounting  significance  in  case 
of  bankruptcy,  for  in  two  of  these  kinds  of  proprietorship  entries 
have  to  show  individual  liability  and  payment,  and  in  the  other 
no  such  entries  are  required.  In  private  proprietorships,  control 
is  direct;  but  in  corporations  it  is  by  a  representative  body,  a 
board  of  directors,  elected  by  the  stockholders.  This  has  ac- 
counting significance  in  that  authorization  for  transactions  must 
be  shown  —  for  the  auditor  must  know  that  what  was  done  was 
authorized,  and  his  evidence  is  the  minutes  of  the  stockholders' 
and  directors'  meetings.  From  the  general  accounting  point  of 
view,  except  for  the  technical  matters  just  mentioned,  which  a 
book  of  this  elementary  sort  cannot  discuss,  the  essential  differ- 
ence between  a  corporation  and  a  private  ownership  is  that  the 
private  ownership  usually  recognizes  at  all  times  the  share  of  the 
business  owned  by  each  proprietor  in  terms  of  dollars  and  cents, 
whereas  in  a  corporation  the  proprietorship  is  not  covered  by 
accounts  with  individuals,  but  by  an  account  or  accounts  repre- 
senting the  whole  group  of  stockholders,  and  then  no  one  accoimt 
may  even  attempt  to  give  the  value  in  dollars  and  cents  of  the  to- 
tal proprietorship.    The  chief  proprietorship  account  is  therefore 


2SO  THE  FUNDAMENTALS  OF  ACCOUNTING 

peculiar  in  its  nature  and  needs  careful  observation.  Under 
recent  practice  two  kinds  of  certificates  of  ownership  are  issued, 
one  with  and  the  other  without  par  value.  We  will  discuss  first 
the  older,  with  par  value. 

Capital  Stock  Account  in  Practice.  Capital  Stock  covers  the 
face  or  par  value,  usually  $ioo,  of  stock  certificates.  It  is  a  con- 
trolling account  kept  in  the  main  ledger,  and  is  matched  by  a 
stockholders'  ledger  in  which  are  accounts  showing  how  many 
shares  of  stock,  of  what  par  value,  are  held  by  each  individual  stock- 
holder. This  ledger  is  used  to  determine  the  amount  of  dividends 
payable  to  each  stockholder,  and  voting  rights  at  stockholders' 
meetings;  and  of  course  all  transfers  of  stock  are  entered  in  it. 
Often  a  corporation  issues  two  or  more  kinds  of  stock,  common 
and  preferred,  or  common  and  two  kinds  of  preferred,  first  and 
second.  Preferred  stock  is  a  first  claim  to  dividends  up  to  a  fixed 
percentage  of  dividend,  and  commonly  has  a  preference  over 
common  in  distribution  of  assets  in  case  of  dissolution;  common 
stock  is  a  claim  to  all  dividends  and  assets  after  the  claims  of  pre- 
ferred stock  are  satisfied.  So  if  profits  are  very  high,  common 
stock  is  often  worth  more  than  preferred,  but  if  profits  are  low  or 
moderate,  preferred  is  likely  to  be  worth  more  than  common. 
The  accounts  distinguish  preferred  from  common,  as  Preferred 
Capital  Stock  and  Common  Capital  Stock,  but  there  is  no  other 
accounting  distinction  that  needs  to  be  made  between  them,  and 
what  is  said  later  about  Capital  Stock  applies  to  each  as  each  is 
concerned.  Theoretically  the  par  value  is  supposed  to  represent 
actual  value  of  property  invested  in  the  corporation,  but  in  reality 
it  may  represent  either  more  or  less.  In  some  States,  the  law  for- 
bids the  issue  of  stock  for  a  larger  par  value  than  the  amount 
actually  invested  in  the  company,  but  no  State  forbids  an  issue  of 
stock  smaller  than  the  investment.  Since,  moreover,  values  are 
i^f  ten  problematical  and  other  things  than  cash  can  be  accepted  in 
return  for  stock  (like  real  estate,  machinery,  and  patent  rights), 
even  where  the  intent  is  to  issue  stock  only  to  match  actual  in- 
vestment it  is  hardly  possible  to  know  that  the  stock  is  repre- 
sented by  actual  value  in  property  or  in  rights.  Many  States, 
moreover,  allow  stock  to  be  issued  in  excess  of  the  investment, 
and  to  be  issued  when  only  a  portion  of  the  amount  subscribed  for 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     25 1 

it  is  paid.  In  consequence,  it  may  be  stated  that  the  relation  be- 
tween the  capital  stock  account  and  the  investment  is  not  fixed 
by  either  law  or  custom.  One  must  know  the  circumstances  of 
the  case  before  one  can  say  in  any  particular  case  what  the  capital 
stock  account  represents.  This,  however,  is  not  the  only  uncer- 
tainty; for  many  corporations  credit  Capital  Stock  for  the  amount 
authorized,  even  if  it  has  not  been  subscribed  for.  So  both  with 
respect  to  the  value  represented  by  the  stock  and  the  condition  of 
the  stock  itself,  the  accoimt  for  capital  stock  gives  httle  informa- 
tion. All  we  can  say  as  a  general  statement  is  that  Capital  Stock 
represents  the  par  value  of  stock  certificates  (that  value  being 
sometimes  actual  and  sometimes  purely  artificial),  and  that,  if 
there  are  no  items  on  the  other  side  of  the  balance  sheet  showing 
that  the  issue  has  not  been  paid  for  or  completed,  the  assumption 
is  safe  that  (supposing  the  books  kept  under  some  reasonable 
bookkeeping  method)  the  stock  has  been  issued  and  is  in  the 
hands  of  stockholders.  Par  value,  in  turn,  has  little  significance: 
it  is  merely  the  figure  on  which  dividends  are  based.  If  dividends 
are  5%,  the  5%  is  applied  to  the  par  value  of  the  stock,  $100,  or 
$50,  or  $10,  or  $1,  as  the  case  may  be.  The  various  necessary 
qualifications  of  these  statements,  and  the  necessary  methods  to 
make  always  perfectly  clear  just  what  is  the  status  of  capital 
stock,  are  discussed  in  the  following  paragraphs. 

Distinction  Between  Issue  and  Sale.  Confusion  sometimes 
exists  between  issue  of  stock  and  sale  of  stock.  It  should  be  ob- 
served that  a  corporation  on  its  principal  books  knows  no  stock- 
holders as  individuals,  but  recognizes  them  only  as  holders  of 
stock  certificates.  When,  therefore,  the  full  authorized  stock  has 
been  issued,  no  one  can  become  a  stockholder  except  by  buying 
stock  from  some  one  else.  Such  transfers  of  stock  between  indi- 
viduals, whatever  the  price  paid,  do  not  affect  the  accounts  of  the 
corporation  except  on  the  subordinate  stockholders'  ledger,  of 
course,  for  the  amoimt  of  capital  stock  is  not  affected  and  the  assets 
of  the  company  are  not  affected  by  any  exchange  between  individ- 
uals. The  discussion  following  is  concerned  chiefly  with  entries  for 
the  issue  of  stock  in  the  first  instance,  in  which  the  corporation 
gets  what  is  paid  for  the  stock  —  in  other  words,  stockholders' 
investment.    The  only  concern  of  the  corporation  in  transfers 


252  THE  FUNDAMENTALS  OF  ACCOUNTING 

of  stock  later,  except  the  record  of  transfer  on  the  stockholders' 
ledger,  is  when  the  stock  has  once  been  issued  and  later  becomes 
the  property  of  the  company,  as  we  shall  observe  in  due  course. 

The  Proper  Method  of  Handling  Capital  Stock.  It  is  obvious 
that  any  bookkeeping  method  that  leaves  in  doubt  the  status  of 
capital  stock  is  deficient.  Capital  stock  authorized  should  be 
distinguished  from  (i)  that  subscribed  for  but  not  issued,  (2)  that 
subscribed  for  but  later  forfeited,  (3)  that  paid  for  but  not  issued, 
(4)  that  issued,  and  (5)  that  once  issued  but  now  back  in  the 
treasury.  It  is  possible  to  keep  separate  accounts  for  each  of 
these  aspects  of  capital  stock,  and  for  most  of  them  it  is  worth 
while  if  the  stock  has  so  many  aspects.  As  was  pointed  out  in  the 
preceding  chapter,  ledger  accounts  can  be  kept  for  all  sorts  of 
statistical  figures  if  they  are  expressible  in  dollars  and  cents. 
Here,  for  example,  we  may  have  on  one  side  Capital  Stock  Au- 
thorized, Capital  Stock  Subscribed,  Capital  Stock  Paid  For, 
Capital  Stock  Issued,  etc.,  and  on  the  other  side  Capital  Stock 
Unsubscribed,  Capital  Stock  Subscriptions,  Capital  Stock  For- 
feited, Capital  Stock  Donated,  etc.  It  is  not  worth  while  in  a 
book  of  this  sort  to  take  up  all  the  conditions  that  apply  to  stock, 
for  the  variations  of  law  among  the  States  create  many.  We  will 
confine  ourselves  to  normal  conditions  of  sound  corporate  policy, 
assuming  (i)  that  in  origin  stock  is  issued  only  when  subscribed 
for,  that  is,  that  it  is  not  sold  by  the  issuing  corporation  like  a 
conunodity  but  the  formality  of  subscription  is  used,  though  it 
may  be  sold  by  the  corporation  if  reacquired,  and  (2)  that  it  is 
issued  only  when  paid  for.  The  titles  used  are  chosen  because 
they  seem  best  to  suggest  the  content  of  the  accounts,  but  othei 
titles  will  serve  if  they  do  not  lead  to  confusion,  as  some  titles 
often  used  occasionally  do. 

Unsubscribed  Capital  Stock  Authorized.  It  is  by  no  means 
essential  to  show  stock  authorized,  for  the  figure  is  purely  statisti- 
cal. If,  however,  it  is  desired  to  show  the  margin  by  which  the 
company  may  receive  new  subscriptions,  this  may  well  appear 
on  the  ledger.  The  account  for  it.  Unsubscribed  Capital  Stock 
Authorized,  is  of  course  credited  for  the  legal  authorization,  for 
the  authorization  to  issue  stock  is  the  original  source  of  the  assets 
which  are  received  by  the  investment  of  stockholders.    The  ac- 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS      253 

count  to  be  debited  represents  the  blank  stock  certificates  availa- 
ble for  issue,  and  may  be  called  Unsubscribed  Unissued  Stock. 
As  soon,  however,  as  any  of  this  stock  is  subscribed  for,  the  com- 
pany has  reduced  its  margin  of  stock  for  which  it  may  receive 
subscriptions,  and  Unsubscribed  Capital  Stock  Authorized  should 
be  debited  to  show  this  fact  on  the  books.  The  balance  of  this 
account,  therefore,  represents  not  the  total  authorization,  but  the 
amount  for  which  the  company  is  still  authorized  to  receive  sub- 
scriptions, as  we  shall  see  below. 

Subscriptions.  When  an  intending  investor  in  a  corporation 
subscribes  for  its  stock,  he  gives  his  pledge  to  pay  it  something, 
and  it  gives  him  a  pledge  to  issue  the  stock  if  he  fulfills  his  pledge. 
From  the  point  of  view  of  each  a  double  aspect  appears.  The 
corporation  gets  an  asset  and  assimies  a  liability.  Both  should 
appear  on  its  books.  It  should  debit  Subscriptions  to  Capital 
Stock,  and  credit  Capital  Stock  Subscribed.  The  former  repre- 
sents its  possession  of  a  promise  of  the  subscriber  to  pay,  akin  to 
Notes  Receivable,  and  the  latter  represents  its  promise  to  render  a 
service,  akin  to  Notes  Payable.  Usually  subscriptions  are  pay- 
able in  instalhnents,  and  then  various  installment  accounts,  like 
Subscription  Installment  #1,  are  substituted  for  the  single  Sub- 
scriptions to  Capital  Stock  suggested  above.  If  we  have  an  ac- 
count for  Unsubscribed  Capital  Stock  Authorized,  however,  as 
suggested  in  the  preceding  paragraph,  still  another  entry  is  neces- 
sary at  the  time  the  subscription  is  received.  The  receipt  of  these 
subscriptions  has  reduced  the  authorization  to  take  subscrip 
tions.  It  has  not  yet  reduced  the  right  to  issue  stock,  for  none 
has  yet  been  issued,  but  already  we  haye  shown  the  pledge  to 
issue,  in  Capital  Stock  Subscribed,  and  hence  it  is  wise  to  reduce 
at  once  our  balance  of  authorization,  lest  we  may  receive  over- 
subscriptions inadvertently.  Our  unsubscribed  unissued  stock 
is  also  reduced,  of  course,  by  receiving  these  subscriptions,  and 
hence  we  should  reduce  the  account  representing  it.  We  merely 
reverse  our  original  entry  of  authorization  by  the  amount  now 
subscribed  for  —  debiting  Unsubscribed  Capital  Stock  Author- 
ized and  crediting  Unsubscribed  Unissued  Capital  Stock.  When 
payment  is  made,  Cash  is  debited,  and  Subscriptions  to  Capital 
Stock,  or  Instalhnent  #1,  etc.,  is  credited.    The  payment  may  in- 


254  THE  FUNDAMENTALS  OF  ACCOUNTING 

volve  another  entry,  moreover.  If  the  subscription  is  paid  in  full, 
the  stock  should  be  issued,  and  entry  must  be  made  for  fulfillment 
of  the  obligation  by  the  company.  As  we  debit  Notes  Payable 
and  credit  Cash  when  we  pay  a  note,  so  here  we  debit  Capital 
Stock  Subscribed  (the  account  representing  our  liability  to  issue 
stock)  and  credit  Capital  Stock  (the  account  representing  the 
actual  issue).  When  all  subscriptions  are  paid  and  the  stock  is 
issued,  the  entries  made  will  cancel  the  old  debit  to  Subscrip- 
tions and  credit  to  Stock  Subscribed,  and  the  net  effect  is  just 
what  we  want  in  the  end,  Cash  debited  and  Capital  Stock  cred- 
ited, with  all  the  intermediate  steps  shown.  These  intermediate 
steps,  as  a  matter  of  fact,  should  usually  show,  for  it  is  important 
to  keep  track  of  installments.  Where  the  law  provides  that  stock 
shall  not  be  issued  until  fully  paid  for,  collections  may  be  made  in 
several  installments  before  any  stock  is  issued;  and  hence  the  entry 
for  issue  will  not  parallel  the  individual  entries  for  payments,  but 
will  be  made  only  after  a  series  of  payment  entries. 

Illustrative  Entries.  We  may  now  well  review  our  progress  up 
to  this  point  by  observing  concrete  entries.  Let  us  suppose:  (a) 
the  authorized  capital  stock  is  $500,000;  (b)  $400,000  is  sub- 
scribed for  at  par,  payable  in  two  installments  of  $200,000  each; 
and  (c)  one  installment  is  paid. 

(a)  Unsubscribed  Unissued  Capital  Stock  500^000 

To  Unsubscribed  Capital  Stock  Authorized  500,000 

(b)  Subscriptions  to  Capital  Stock  Installment  #1  200,000 
Subscriptions  to  Capital  Stock  Installment  #2  200,000 

To  Capital  Stock  Subscribed  400.000 

Unsubscribed  Capital  Stock  Authorized  400,000 

To  Unsubscribed  Unissued  Capital  Stock  400,000 

(c)  Cash  200,000 

To  Subscriptions  to  Capital  Stock  Installment  #1  200,000 

Our  trial  balance  then  looks  as  foUows: 

Unsubscribed  Unissued  Capital  Stock  100,000 

Unsubscribed  Capital  Stock  Authorized  100,000 

Subscriptions  to  Capital  Stock  Installment  #2  200,000 

Capital  Stock  Subscribed  400,000 

Cash  200,000  

500,000         500,000 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS      255 

Our  trial  balance  shows  us  all  the  facts  —  $100,000  margin 
available  for  subscription  (in  two  accounts,  one  debit  and  one 
credit),  $200,000  collectible  on  old  subscriptions,  $200,000  in 
cash,  and  obligation  to  issue  $400,000  of  stock  when  the  second 
installment  is  paid.  Now  suppose  (d)  the  second  installment  is 
paid,  and  the  stock  is  issued.    The  two  entries  follow. 

(d)  Cash  200,000 

To  Subscriptions  to  Capital  Stock  Installment  §2  200,000 

Capital  Stock  Subscribed  400,000 

To  Capital  Stock  400,000 

Our  trial  balance  will  now  show  our  balance  of  authorization, 
our  cash,  our  capital  stock,  and  nothing  more.  It  shows  what 
it  should.  The  whole  thing  is  much  simplified,  of  course,  by 
omitting  the  authorization  entirely.  Then  entry  (a)  and  the 
second  entry  under  (b)  would  be  omitted,  and  the  first  two 
items  on  the  trial  balance  would  disappear. 

Capital  Stock.  The  usual  practice  is  to  include  in  Capital 
Stock  only  the  figures  for  stock  actually  issued.  If  the  stock  has 
once  been  issued  and  is  reacquired,  by  donation  or  purchase,  it 
still  is  issued  stock  and  is  included  in  Capital  Stock  unless  can- 
celled. Cancellation  is  usually  illegal  without  special  authority. 
That  which  is  held  is  shown  on  the  other  side  of  the  balance  sheet 
under  some  appropriate  title  —  so  that  the  issue  and  the  own- 
ership both  appear,  one  as  a  separate  item,  often  as  Treasury 
Stock  on  the  asset  side  of  the  balance  sheet,  and  the  other  in- 
cluded in  the  total  of  stock  issued.  "Capital  Stock  Issued" 
would  be  a  good  title  for  this  latter  account,  but  the  shorter 
term  is  usual. 

Stock  Issued  at  Above  Par.  Sometimes  stock  is  originally 
issued  at  more  than  par  —  say  120.  This  means  that  the  sub- 
scriber agrees  to  pay  $120  for  a  share  of  stock  having  a  par  value 
of  $100.  This  illustrates  the  statement  made  above,  that  the  par 
value  of  stock  has  no  definite  significance  other  than  the  amount 
which  happens  to  be  incorporated  in  the  certificate  of  ownership. 
A  man  who  takes  stock  at  120  is  investing  $120  in  the  business  (if 
the  stock  has  the  usual  $100  par  value),  but  his  dividends  will  be 
based  on  a  par  value  of  $100.    This  appears  to  involve  a  loss,  but 


2S6  THE  FUNDAMENTALS  OF  ACCOUNTING 

a  little  consideration  shows  that  it  is  not  so.  So  far  as  earnings 
and  dividends  are  concerned,  the  result  would  be  the  same  if  the 
par  value  were  $50  or  $10  and  still  the  investor  invested  in  the 
business  $120.  The  thing  that  earns  profits  is  not  par  value  (a 
mere  name),  but  invested  capital.  The  $120  invested  will  earn 
as  much  whether  the  share  of  stock  given  for  it  has  a  par  value 
of  $100,  or  $50,  or  $10.  The  amount  of  profit  will  be  the  same. 
Suppose  it  to  be,  for  one  share  of  stock,  $12.  If  the  par  value 
of  the  stock  given  is  $100,  the  rate  of  profit  will  be  12%.  If  the 
par  value  of  the  stock  given  is  $50,  it  will  be  24%;  if  $10,  it 
will  be  120%.  In  other  words,  the  same  profit  will  give  a  differ- 
ent percentage  on  different  par  values,  but  when  those  percent- 
ages are  applied  to  the  par  values  for  purposes  of  dividend,  the 
higher  or  lower  rate  obtained  in  the  first  instance  is  entirely  offset 
by  the  application  to  a  lower  or  higher  par  value  for  purposes  of 
distribution.  The  par  value  is  therefore  of  no  consequence  in  this 
connection.  (When  men  say  that  they  had  rather  have  an  in- 
vestment at  a  discount  than  at  a  premimn,  it  is  for  other  reasons 
than  the  rate  of  return  —  usually  because  of  certain  psychological 
factors  in  a  speculative  market.)  Issue  of  stock  at  above  par, 
therefore,  creates  in  accounting  only  the  awkwardness  of  having  a 
credit  to  Capital  Stock  of  par,  and  a  debit  to  an  asset  account  of 
more  than  the  equivalent  figure.  Another  element  needs  record. 
In  this  case,  the  proprietorship  claim  is  not  wholly  covered  by 
Capital  Stock,  for  more  than  par  was  paid.  We  must  conse- 
quently credit  another  proprietorship  account  for  the  amount  of 
investment  in  excess  of  the  par  value  of  stock,  and  the  title  should 
make  clear  what  the  account  represents.  The  usual  title  for  ex- 
cess of  assets  paid  in  over  those  which  are  represented  by  capital 
stock  is  "surplus."  As  surpluses  may  be  earned,  donated,  or  in- 
vested, it  is  desirable  to  distinguish  that  which  is  invested,  and  it 
may  be  called  "  Premium  Surplus."  Our  first  entry  for  receiv- 
ing subscriptions  at  a  premium,  then,  supposing  instead  of  (b) 
on  page  254  we  have  subscriptions  for  $440,000,  is  as  follows: 

Subscriptions  to  Capital  Stock  Installment  #1      22o,cx)o 
Subscriptions  to  Capital  Stock  Installment  #2      220,000 
To  Capital  Stock  Subscribed  400,000 

Premium  Surplus  40,000 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     257 

The  second  entry  for  (b),  page  254,  would  be  unchanged,  for  the 
amount  of  stock  which  has  been  pledged  for  issue  is  still  only 
$400,000.  Entries  (c)  and  (d)  would  be  the  same  except  that  the 
amounts  of  (c)  and  of  the  first  part  of  (d)  would  be  $220,000  each. 
The  last  part  of  (d)  is  still  for  $400,000.  In  other  words.  Pre- 
mium Surplus  is  credited  when  the  subscriptions  are  received,  for 
that  is  when  the  surplus  asset  was  received,  and  needs  no  further 
attention  unless  the  subscriptions  are  forfeited  —  in  which  case 
the  correction  entry  would  correct  Premium  Surplus,  as  well  as 
Subscriptions,  and  Stock  Subscribed.  If  one  does  not  mind  a 
little  extra  bookkeeping  labor,  and  is  hesitant  about  labeling  as 
surplus  mere  promises  to  pay  premium,  one  may  credit  Premium 
Surplus  Subscribed  instead  of  Premium  Surplus  in  the  first  in- 
stance, and  then  when  the  last  installment  of  subscription  is  paid 
debit  Premiimi  Surplus  Subscribed  (to  transfer  it)  and  credit 
Premiiun  Surplus. 

Stock  Issued  at  below  Par.  In  some  respects,  the  issue  of 
stock  at  below  par  is  the  reverse  of  issue  at  above  par.  Legally  it 
is  not  the  reverse,  for  many  States  forbid  issue  at  a  discount. 
Taking  stock  at  below  par  at  its  original  issue  is  taking  it  before  it 
is  fully  paid  for,  and  hence  is  assuming  a  liabiKty  to  make  up  the 
difference  if  the  company  later  becomes  bankrupt,  for  the  law 
recognizes  responsibility  of  stockholders  up  to  the  par  value  of 
their  stock;  but  the  deficiency  in  investment  may  be  made  up  out 
of  later  earnings  if  the  company  decides  to  apply  sufficient  earn- 
ings to  that  purpose  rather  than  to  dividends.  When  issue  of 
stock  at  below  par  is  allowable,  the  entries  for  the  discount  are 
similar  to  those  for  premium  except  that  they  are  reversed.  The 
subscriptions  being  for  less  than  par,  the  assets  are  less  in  amount 
than  the  obligation  to  issue  stock  assimied,  and  hence  extra 
debits  are  necessary  —  really  deductions  from  ownership  claims. 
Briefly,  the  entry  for  subscription  is  as  follows: 

Subscriptions  to  Capital  Stock  360,000 

Discount  on  Capital  Stock  40,000 

To  Capital  Stock  Subscribed  400,000 

On  payment,  the  entry  is 

Cash  360,000 

To  Subscriptions  to  Capital  Stock  360,000 


2S8  THE  FUNDAMENTALS  OF  ACCOUNTING 

For  the  immediately  following  issue,  the  entry  is 

Capital  Stock  Subscribed  4CX),ooo 

To  Capital  Stock  400,000 

Then  the  trial  balance  reads 

Cash  360,000 

Discount  on  Capital  Stock  40,000 

Capital  Stock  400,000 

400,000         400,000 


In  a  sense,  this  Discount  on  Capital  Stock  represents  an  asset,  for 
it  represents  a  claim  that  in  case  of  bankruptcy  may  be  made  by 
creditors  against  individual  stockholders;  but  collection  is  so 
bound  with  red  tape  and  with  exemptions  that  often  it  is  of 
slight  practical  value.  That  is  why  some  States  forbid  the  issue 
of  stock  until  fully  paid  for.  Most  companies  try  early  to  fill 
the  void  left  by  discounts,  and  withhold  some  of  their  earnings 
from  distribution  as  dividend,  and  apply  them  by  methods  to 
be  described  later. 

Donations  of  Stock.  Stock  is  sometimes  in  effect  issued  at  a 
discount  by  a  device  which  makes  it  appear  not  to  be  so  issued. 
Sometimes  this  device  is  employed  to  evade  the  letter  of  laws  for- 
bidding issue  at  a  discount,  and  sometimes  it  is  an  evasion  of 
neither  letter  nor  spirit  of  any  law.  In  both  cases  the  process 
usually  begins  with  issue  in  the  ordinary  way  at  par,  and  is  fol- 
lowed by  a  donation  to  the  corporation  by  its  stockholders  of 
some  of  the  stock  which  has  been  issued  to  them.  This  in  effect, 
of  course,  gives  the  stockholder  less  stock  than  the  value  of  the 
assets  turned  in,  and  hence  he  is  in  reaHty  taking  his  stock  at  a 
premium.  If  he  takes  ten  shares  for  $1,000,  and  then  donates 
two  shares,  he  has  left  eight  shares  for  $1,000,  or  the  equivalent  of 
eight  shares  at  1 25.  The  point  is  that  the  shares  are  now  all  fully 
paid  for.  The  par  value  of  them  has  now  been  fully  invested. 
There  is  now  no  Uability  of  any  stockholder  to  pay  more,  and  the 
company  has  in  its  vaults,  fully  paid  for,  two  shares  out  of  ten. 
It  may  do  as  it  pleases  with  these;  it  may  sell  them  for  what  it  can 
get,  or  even  give  them  away  in  a  proper  cause;  for  they  have  once 
been  fully  paid  for,  and  therefore  even  the  severest  law  is  com- 
plied with.  Of  course,  too,  there  is  no  moral  or  other  reason  why 
the  company  should  not  sell  them  for  what  it  can  get,  for  they 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     259 

now  represent  actual  assets  invested  to  cover  their  issue.  But  do 
they?    That  is  the  crux  of  the  whole  matter. 

Donations  for  Evasion.  If  the  assets  turned  in  were  really 
worth  the  par  value  of  the  stock,  no  evasion  has  been  conunitted. 
If,  however,  the  assets  turned  in  are  overvalued,  worth  perhaps 
$800  for  every  $1,000  of  stock  issued,  though  put  on  the  books  for 
$1,000,  the  donation  of  stock  was  no  donation  at  all,  but  only  a 
return  of  stock  never  paid  for;  and  if  never  paid  for,  the  company, 
under  some  State  laws,  has  no  right  to  sell  it  at  less  than  par.  So 
the  evasion  has  been  accomplished  by  a  combination  of  overvalu- 
ing assets  and  then  donating  back  the  stock  representing  the  ficti- 
tious portion  of  the  assets.  The  difficulty  in  detecting  this  lies 
usually  in  learning  what  the  assets  were  really  worth.  Often 
some  of  the  property  given  for  the  stock  consists  of  real  estate, 
machinery,  patents,  good  will,  etc.,  and  the  value  of  these  is  often 
problematical.  If  proof  can  be  given  that  overvaluation  took 
place  and  that  stock  was  issued  for  the  fictitious  value,  creditors  in 
the  case  of  bankruptcy  of  a  corporation  can  recover,  but  the  burden 
of  proof  put  upon  them  is  usually  too  heavy.  Only  in  case  the 
amount  received  for  the  stock  when  sold  after  donation  equals  the 
original  over-issue  can  the  stock  be  deemed  really  fully  paid  for. 

Donations  without  Evasion.  Sometimes  the  donation  is  with- 
out either  intent  or  result  of  evasion.  Often  the  organizers  of  a 
company  have  great  faith  in  its  future  but  do  not  expect  others  to 
have  such  faith.  They  must  personally  offer  special  inducements 
to  get  others  to  invest  with  them.  If  they  need  capital,  they  may 
be  willing  to  surrender  a  part  of  their  shares  of  stock  as  an  induce- 
ment to  others  to  join  them,  in  the  belief  that  with  new  capital 
they  will  recoup  themselves  out  of  the  later  profits.  Even  though 
the  stock  issued  to  them  is  not  greater  in  par  value  than  the  assets 
which  they  have  turned  in,  they  may  be  willing  to  donate  some  of 
it.  If  under  these  conditions  they  do  so,  it  is  clear  that  the  stock 
so  donated  is  truly  once  fully  paid  for,  and  even  if  now  given  away 
the  assets  of  the  business  would  equal  the  capital  stock.  So  the 
company  may  now  sell  the  stock  for  what  it  can  get  (and  there  is 
often  a  psychological  advantage  in  offering  stock  below  par)  and 
not  be  guilty  of  issuing  stock  in  excess  of  assets — indeed,  what 
it  gets  from  such  sales  constitutes  assets  in  excess  of  its  stock. 


26o  THE  FUNDAMENTALS  OF  ACCOUNTING 

Accounting  for  Donations.  No  distinction  of  treatment  can  be 
made  between  the  two  cases  of  donation  given  above,  for  it  is  pre- 
sumed that  whoever  keeps  the  accounts  is  unaware  of  the  over- 
valuation. No  accountant  would  consciously  enter  the  property 
at  an  overvalued  figure,  for  it  is  the  task  of  an  accountant  to  tell 
the  truth.  He  cannot  usually,  unless  he  is  engaged  for  that  pur- 
pose and  is  competent  to  do  it,  investigate  the  value  of  all  prop- 
erty given  in  return  for  stock:  he  is  expected  to  provide  the  en- 
tries for  the  actual  issue  of  stock  as  made.  Unless  engaged  as 
auditor  for  such  a  purpose,  he  is  not  responsible  for  the  propriety 
of  stock  issues,  and  he  will  assume  them  proper  unless  something 
on  the  face  of  things  discredits  them.  Assuming  proper  valua- 
tions as  given  him  by  the  action  of  the  directors,  he  will  treat 
donations  as  bona  fide.  Let  us  now  examine  the  entries.  The 
donated  stock  had  its  origin  in  the  return  of  stock  to  the  corpora- 
tion as  a  gift,  so  that  the  stockholders  have  contributed  to  the 
business  not  only  all  they  originally  invested  but  as  much  more  as 
this  donated  stock  will  bring.  The  total  amount  of  par  value  of 
stock  issued  is  not  increased  by  this  gift,  but  if  the  stock  brings 
anything  by  sale  the  assets  will  be  increased,  and  the  ownership- 
claim  of  the  stockholders  will  be  increased.  Then  the  ownership- 
claim  of  stockholders  will  exceed  the  par  value  of  stock,  and  this 
excess  is  surplus.  We  must  therefore  debit  an  asset  account  for 
the  stock  donated,  and  credit  a  surplus  account  for  the  proprietor- 
ship-claim created  by  the  asset.  Sometimes  Treasury  Stock  is 
debited,  and  Working  Capital  is  credited.  Since  Treasury  StocV 
is  usually  used  for  purchases  by  a  corporation  of  its  own  stock,  it 
had  better  not  be  used  also  for  donated  stock;  and  since  "  working 
capital "  is  vague,  and  is  used  in  common  speech  for  cash,  accounts 
receivable,  and  supplies  needed  to  keep  a  business  in  normal  rim- 
ning  condition,  it  had  better  be  avoided  for  a  very  specific  thing 
like  donations  by  stockholders.  The  following  entry  suggests 
what  has  actually  happened. 

Donated  Capital  Stock 
To  Donated  Surplus 

The  next  question  concerns  the  amount  of  the  entry.  Some 
recommend  that  the  entry  be  made  for  the  amount  that  the  do- 
nated stock  is  likely  to  bring  at  sale.    This  amount  is  usually 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     261 

problematical;  and  hence  the  entry  can  mean  little,  particularly 
as  one  cannot  tell  from  the  balance  sheet  whether  much  stock  is 
entered  at  a  low  price  or  little  stock  at  a  high  price.  In  any  case 
an  adjustment  entry  is  almost  sure  to  be  needed  when  the  stock  is 
actually  sold.  It  seems  wiser,  therefore,  to  enter  such  donations 
at  par  value;  for  the  identical  stock  appears  on  the  other  side  of 
the  balance  sheet  at  par  (in  Capital  Stock),  and  one  is  as  good  as 
the  other.  No  one  is  likely  to  be  deceived  by  the  item,  for  any  one 
knowing  what  donated  stock  is  will  imderstand  that  it  is  on  the 
books  awaiting  disposition  and  is  imlikely  to  bring  par  at  sale. 
When  donated  stock  is  sold  it  is  obvious  that  the  amount  of  dis- 
coimt  suffered  on  the  sale  is  just  so  much  reduction  in  the  amount 
of  the  nominal  donation.  So  Donated  Surplus  is  debited.  If  we 
suppose,  therefore,  that  the  donation  given  above  was  of  $50,000 
par  value  of  stock,  and  that  the  stock  was  sold  for  80,  the  entry 
for  the  sale  would  be  as  follows: 

Cash  40,ocx> 

Donated  Surplus  io,ocx) 

To  Donated  Capital  Stock  50,000 

Donations  by  Individuals  to  Individuals.  Sometimes  the  do- 
nations do  not  go  through  the  treasury  of  the  corporation,  but  are 
made  direct  to  new  stockholders  by  old  stockholders;  i.e.,  the 
original  stockholders  make  an  agreement  with  each  other  that 
each  will  donate  a  certain  proportion  of  his  stock  for  a  common 
pool,  and  that  out  of  this  pool  will  be  given  to  new  stockholders  a 
certain  number  of  shares  as  a  bonus  with  each  block  of  shares 
purchased.  Since  this  is  a  purely  private  matter,  between  old 
stockholders  as  individuals  and  new  stockholders,  it  does  not  ap- 
pear on  the  books  of  the  corporation  in  any  form.  The  only 
question  regarding  its  propriety  is  the  propriety  of  the  original 
issue  —  that  is,  whether  the  assets  given  were  overvalued;  but 
even  that  is  not  a  question  of  donation,  but  of  issue. 

Forfeited  Subscriptions.  The  law  regarding  forfeitures  of  sub- 
scriptions is  not  uniform  among  the  States,  and  it  is  unnecessary 
in  a  book  of  this  type  to  take  up  the  various  accounting  require- 
ments. Suffice  it  to  say  that  when  a  subscription  has  been  for- 
feited, the  books  must  show  several  things:  (i)  the  loss  of  the 
asset  in  the  form  of  further  subscriptions  collectible;  (2)  the  can- 


262  THE  FUNDAMENTALS  OF  ACCOUNTING 

cellation  of  the  pledge  to  issue  stock;  (3)  the  cancellation  of  any 
premium  or  discount  involved  in  the  subscription;  (4)  the  credit 
to  a  special  surplus  account  of  any  amounts  forfeited  to  the  com- 
pany by  the  forfeiting  subscriber;  (5)  any  liability  that  the  com- 
pany may  have  to  meet,  contingent  or  otherwise,  for  actual  pay- 
ments by  the  forfeiting  stockholder.  Working  out  entries  for 
these  is  interesting  exercise  in  actual,  contingent,  and  statistical 
accounts,  and  is  recommended  for  original  work  on  the  part  of  the 
student. 

Converting  Private  into  Corporate  Business.  The  method  of 
converting  a  private  business  into  a  corporation  is  more  or  less 
obvious.  The  steps  are  merely  the  logical  steps  required  by  the 
nature  of  each  form  of  business.  If  the  new  business  is  to  take 
over  the  old  books,  the  only  new  accounting  features  are  the  sub- 
stitution of  Capital  Stock  for  the  old  proprietorship.  If  the  old 
partners  take  stock  equal  in  par  value  to  the  value  of  the  assets  as 
shown  by  the  books,  the  entries  simply  give  their  subscription  in 
the  ordinary  way,  as  shown  above,  and  then  cancel  the  old  pro- 
prietorship-claim for  the  new  capital  stock  —  the  surrender  of  the 
property  to  the  corporation.  Supposing  the  old  net  assets  are 
worth  $500,000,  are  on  the  books  for  that  figure,  and  that  John 
Doe  and  Richard  Roe  are  the  partners,  who  are  to  take  stock  of  a 
par  value  of  $500,000,  we  get  the  following: 

Subscriptions  to  Capital  Stock  500,000 

To  Capital  Stock  Subscribed  500,000 

John  Doe  250,000 

Richard  Roe  250,000 

To  Subscriptions  to  Capital  Stock  500,000 

Capital  Stock  Subscribed  500,000 

To  Capital  Stock  500,000 

The  second  entry  cancels  the  old  credits  to  partners  as  proprie- 
tors, on  the  transfer  of  their  rights  as  individual  proprietors  in 
payment  of  their  subscriptions;  and  the  explanation  portions  of 
the  entries  give  the  whole  story  of  the  transaction.  If  the  old 
business  is  worth  more  than  the  value  of  the  assets  as  shown  by 
the  books,  because  of  the  good  will,  the  first  task  is  to  put  the 
good  will  on  the  books  and  credit  it  to  the  old  proprietors,  and 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     263 

then  make  the  transfer  as  above.  If  the  old  books  are  not  to 
be  taken  over,  a  clean  sweep  is  made  of  the  old  accounts,  show- 
ing that  the  old  assets  are  withdrawn  from  the  old  business  by 
the  proprietors  and  the  liabilities  are  assumed  by  them,  thus  clos- 
ing all  old  accounts,  and  then  the  new  books  are  started  as  if 
there  had  been  no  old  business  —  debiting  the  assets,  crediting 
the  liabilities,  and  issuing  capital  stock  for  the  difference,  just  as 
in  the  case  of  a  corporation  with  no  predecessor  but  assimiing 
certain  liabiHties. 

Confusion  between  Profits  and  Assets.  Before  we  take  up  the 
distribution  of  profits  in  a  corporation,  we  should  realize  that  in 
common  speech  there  is  much  confusion  between  profits  and  as- 
sets. We  say,  "The  corporation  has  distributed  its  profits." 
This  is  perfectly  clear  and  perfectly  correct;  but  it  leads  to  confu- 
sion of  students  of  accounting  imless  they  realize  that  what  is 
really  meant  is  that  the  corporation  has  distributed  "assets 
equivalent  to  the  amount  of  profits.''  One  must  take  care  not  to 
confuse  the  assets  with  the  profits,  or  the  asset  accounts  with  the 
profit  accounts.  Profit  in  the  accounting  sense  is  the  amount  by 
which  assets  have  increased  as  a  result  of  doing  business,  and 
hence  it  is  the  increase  of  proprietors'  claim  to  assets:  and  this  is 
complementary  to  the  assets  themselves.  That  is,  profit  from  the 
accounting  point  of  view,  like  everything  else,  has  its  double 
aspect  —  the  asset  which  is  gained,  and  the  claim  to  that  asset. 
The  claim  to  the  asset  is  not  destroyed  imless  the  asset  is  de- 
stroyed —  though  of  course  it  may  be  transferred.  The  satis- 
faction of  the  claim  to  the  asset,  on  the  other  hand,  must  lie 
in  the  surrender  of  the  asset  —  through  the  payment  of  divi- 
dends, for  example.  So  the  accoxmt  for  profit  does  not  repre- 
sent the  assets  which  were  gained,  but  the  ownership  of  what 
was  gained;  and  the  asset  accounts  represent  all  assets,  includ- 
ing those  which  have  been  derived  from  gains,  but  give  no  hint 
of  ownership. 

Distribution  of  Profits.  Since  corporations  have  no  accounts, 
on  their  general  books,  with  individual  stockholders,  the  sharing 
of  profits  among  individuals  cannot  be  shown  on  the  general 
books.  The  individual  stockholder,  moreover,  has  no  claim  to 
the  distribution  of  profits  until  such  distribution  has  been  voted 


264  THE  FUNDAMENTALS  OF  ACCOUNTING^ 

by  the  directors,  and  therefore  he  can  have  no  credit  individually 
for  profits  merely  because  they  have  been  earned.  When  divi- 
dends are  declared,  a  lump  sum  of  profits  is  carried  to  a  dividend 
account  as  a  liability;  and  this  is  then  paid  to  the  individual 
stockholders,  on  the  strength  of  the  records  of  the  stockholders* 
ledger,  and  is  debited  to  the  dividend  account.  It  is  common  to 
establish  a  separate  account  on  the  ledger  for  each  dividend  de- 
clared, and  to  make  a  special  bank  deposit  for  the  amount,  and 
then  to  draw  dividend  checks  on  that  bank  account.  The  recon- 
ciliation of  the  bank  statement  will  show  the  dividends  unpaid. 
Before  dividends  are  declared  the  profits  are  carried  to  a  general 
account  for  profits,  and  then  the  amount  to  be  paid  in  dividends 
is  taken  from  this  account  and  credited  to  Dividends,  which  is 
debited  when  the  dividends  are  paid.  Sometimes  the  dividend  is 
less  than  the  profit  for  the  period,  and  sometimes  more.  It  can 
seldom  be  exactly  equal  to  the  profit,  for  the  figure  of  profit  will 
seldom  be  exactly  divisible  by  the  niunber  of  shares  of  stock. 
Consequently  an  indivisible  residue  may  accumulate  and  then  be 
drawn  upon.  For  more  important  reasons,  however,  the  divi- 
dend is  likely  to  be  less  than  the  profits:  it  is  well  to  hold  back  a 
part  of  the  profits  for  emergencies,  or  to  increase  the  capital  along 
with  the  growth  of  the  business.  The  profits  retained  may  be 
shown  in  any  one  or  more  of  several  accoxmts  according  to  cir- 
amastances. 

Undivided  Profits.  An  account  called  "Undivided  Profits"  is 
sometimes  used  for  small  residues,  when  no  permanent  particular 
retention  of  them  is  contemplated.  Sometimes  this  account  is 
used  as  a  pool,  so  to  speak,  into  which  are  put  the  profits  of  the 
year  before  dividends  are  declared  and  in  which  is  left  any  residue. 
When  put  to  this  use,  dividends  are  declared  out  of  this  pool,  and 
hence  may  be  more  or  less  than  the  profits  of  the  year  without 
this  fact  showing  conspicuously.  Suppose  the  undivided  profits 
of  the  preceding  year  to  be  $15,000,  the  profits  of  the  year  to  be 
$35,000,  and  the  dividends  declared  to  be  $40,000.  The  following 
entries  will  be  made. 

Loss  and  Gain  3SiOOO 

To  Undivided  Profits  3S»ooo 

(Undivided  Profits  now  shows  a  credit  of  $50,000) 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     265 

Undivided  Profits  40,cxx> 

To  Dividends  40,000 

Dividends  40,000 

To  Cash  40,000 

At  the  end,  Undivided  Profits  shows  a  balance  of  $10,000,  as  it 
should,  for  the  dividends  have  depleted  the  old  balance  by  $5,000 
because  they  exceeded  the  profit  of  the  year.  If  one  wishes  to 
emphasize  the  fact  that  dividends  were  paid  in  part  out  of  profits 
of  the  past,  it  would  be  better  to  take  dividends  out  of  profits  (as 
far  as  profits  are  adequate)  before  transferring  profits  to  Undi- 
vided Profits,  thus, 

Loss  and  Gain  35,ooo 

Undivided  Profits  5, 000 

To  Dividends  40,000 

This  method  shows  clearly  on  its  face  the  relation  between  the 
profits  and  the  dividends  —  as  also  between  the  imdivided  profits 
and  the  dividends.  If  the  dividends  had  been  only  $30,000,  we 
should  have  had  the  following: 


Loss  and  Gain 

3S,ooo 

To  Dividends 

30,000 

Undivided  Profits 

5,000 

This  shows  that  not  all  profits  were  applied  to  dividends.  Merely 
as  a  matter  of  emphasis,  therefore,  it  seems  desirable  to  transfer  to 
Undivided  Profits  only  the  part  of  new  profits  not  divided,  rather 
than  to  transfer  all  profits  and  then  take  out  the  divided  portion. 
To  this  account  may  be  credited  or  charged  corrections  of  profits 
or  losses  shown  erroneously  by  the  books  in  earlier  periods,  as  is 
bound  to  happen  from  time  to  time  with  estimated  figures,  like  the 
allowances  for  depreciation,  for  bad  debts,  and  for  discounts. 
This  account  is  used  also  as  a  sort  of  reservoir  for  equalizing  divi- 
dends. If  earnings  are  rather  irregular  year  by  year  but  do  not 
depart  very  seriously  from  the  average  over  three-  or  four-year 
periods,  in  especially  good  years  a  part  of  the  profits  may  be  left 
in  this  account  and  in  one  of  the  recurrent  lean  years  may  be 
drawn  for  dividends.  Sometimes  the  account  is  called  simply 
"Profit  and  Loss."    Always,  of  course,  Undivided  Profits  repre- 


266  THE  FUNDAMENTALS  OF  ACCOUNTING 

sents  a  claim  of  stockholders  to  assets  arising  from  gains,  and 
does  not  itself  represent  any  assets. 

Surplus.  If  a  part  of  the  undivided  profits  are  intended  to  be 
kept  permanently,  or  for  a  long  time,  in  the  business  as  a  general 
provision  for  safety,  or  for  some  special  purpose,  it  is  well  to  trans- 
fer the  amount  from  Undivided  Profits  to  a  special  account;  for 
the  very  title  "Undivided  Profits"  is  a  temptation  to  divide,  and, 
as  we  have  seen,  the  account  is  a  sort  of  reservoir  for  drawing  in 
lean  years.  Hence  profits  intended  to  be  held  and  not  distrib- 
uted should  be  specially  labeled,  and  the  best  way  to  label  them  is 
to  put  them  into  an  account  with  a  title  that  serves  to  indicate 
why  the  items  are  carried  separately.  The  generic  title  for  such 
accounts  is  Surplus;  but  there  may  be  any  number  of  surplus  ac- 
counts, some  with  and  some  without  the  word  "surplus"  in  their 
titles,  and  often  there  is  a  single  Surplus.  In  the  last  case,  the 
title  usually  indicates  merely  that  the  amounts  carried  to  that 
account  are  not  intended,  at  least  at  present,  for  dividends  — 
though  some  corporations  make  no  distinction  between  Undi- 
vided Profits  and  Surplus,  but  carry  all  balances  of  profit  imdis- 
tributed  as  Surplus. 

Special  Surpluses.  So  many  special  purposes  may  lead  to  the 
accumulation  of  profits  that  it  is  virtually  impossible  as  well  as 
undesirable  to  specify  them  here.  Not  many  are  likely  to  be  in 
force  in  any  one  business  at  one  time,  however.  Seldom  will  more 
than  three  or  four  be  found  in  one  corporation.  Such  things  as 
acquisition  of  new  properties,  pa3mfient  of  debt,  provision  to  meet 
extraordinary  fire  losses,  provision  for  pensions  of  employees,  are 
good  illustrations.  Sometimes  the  term  "reserve"  is  used  in 
preference  to  "surplus."  " Surplus "  emphasizes  the  fact  that  the 
net  assets  (above  all  debts)  exceed  the  amount  of  capital  stock; 
"reserve"  emphasizes  the  fact  that  a  part  of  the  profits  (or  rarely 
original  investment  in  excess  of  capital  stock  issued  for  it)  have 
been  reserved,  from  distribution  as  dividends,  for  the  purpose 
indicated  in  the  title  of  the  reserve  account;  but  they  equally 
represent  the  ownership  of  net  assets  in  excess  of  the  par  value  of 
capital  stock  —  provided  assets  are  not  overvalued.  This  last 
proviso,  however,  is  of  the  utmost  importance.  Unfortunately 
many  accountants  use  the  term  "reserve"  not  for  a  special  sur- 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     267 

plus,  which  represents  excess  of  net  assets  over  capital  stock,  but 
for  a  mere  contra  account  representing  overvaluation  of  assets, 
exactly  akin  to  what  we  have  previously  called  an  "allowance.'* 
There  is  a  world  of  difference  between  these  two  things.  The  dis- 
tinction can  well  be  pointed  out  by  a  simple  balance  sheet.  Sup- 
pose we  have 

Assets  $180,000        Liabilities  $  60,000 

Capital  Stock  100,000 

Reserve  for  Depreciation     20,000 

$180,000  $180,000 

If  this  reserve  is  a  surplus  specially  labeled  because  accumulated 
as  a  safety-first  precaution  against  the  danger  of  a  sudden  dis- 
placement of  machinery  by  new  inventions,  etc.,  it  means  that  the 
assets  are  actually  $180,000,  and  as  the  Uabilities  are  only  $60,000 
and  the  capital  stock  only  $100,000  there  is  stockholders'  owner- 
ship-claim to  $20,000  of  assets  more  than  the  amount  represented 
by  the  capital  stock.  If,  on  the  other  hand,  this  reserve  repre- 
sents "a  hole  in  the  assets,"  the  property  has  already  depreciated 
by  $20,000  below  the  figure  shown  on  the  books,  and  therefore  no 
surplus  exists.  The  account  got  its  credit  not  from  earnings,  but 
in  Heu  of  a  credit  to  the  account  representing  the  asset  which  has 
depreciated.  The  title  is  misleading,  and  that  is  why  we  have 
used  the  term  "allowance."  Before  attempting  to  use  figures 
that  include  a  "reserve,"  therefore,  one  should  learn  which  sort  of 
reserve  is  meant.  One  is  the  contra  or  complement  of  "assets 
which  must  not  be  counted  as  available  for  general  use^  because 
they  will  be  needed  to  make  up  unreported  overvaluation  in  other 
assets,  and  hence  are  reserved  for  that  purpose  —  they  will  not 
help  in  future  contingencies, /tjr  the  hole  which  they  must  fill  has 
already  been  made'']  the  other  is  the  contra  or  complement  of 
"  assets  which  are  available  for  general  use,  but  will  not  be  dis- 
tributed as  dividends,  because  they  may  be  needed  to  fill  future 
needs  —  but  if  no  unexpected  future  need  arises  they  are  clear 
gain  J  ^ 

Deficit  When  operations  have  resulted  in  losses,  so  that  the 
assets,  after  all  liabilities  are  paid,  are  insufficient  to  match  the 
par  of  capital  stock,  the  losses  are  commonly  carried  in  an  account 


268  THE  FUNDAMENTALS  OF  ACCOUNTING 

called  "Deficit."  This  appears  on  the  debit  side  of  the  balance 
sheet,  though  it  is  not  an  asset.  It  represents  a  reduction  in  pro- 
prietors' ownership-claims;  but  since  such  claims  have  already 
been  given  an  artificial  figure  representing  the  par  value  of  stock 
issued,  we  cannot  now  reduce  the  figure  on  the  books  and  the  bal- 
ance sheet  until  the  stock  itself  is  cancelled,  and  a  loss  does  not 
accomplish  this  result.  So  the  deficit,  not  deductible  on  the  credit 
side  of  the  balance  sheet,  must  be  added  on  the  debit  side.  In- 
deed, it  is  in  one  sense  an  asset:  it  is  available  to  the  managers  for 
explaining  what  has  become  of  the  stockholders'  property.  They 
can  legally  settle  their  accountability  to  the  stockholders  as  well 
by  pointing  to  the  deficit  as  by  pointing  to  cash  or  merchandise  — 
however  unhappy  such  a  showing  may  be.  Often  the  deficit  ap- 
pears on  the  books  as  simply  Profit  and  Loss.  Since  this  title 
covers  both  losses  and  gains,  one  cannot  tell  whether  gain  or  loss 
is  involved  until  one  observes  on  which  side  of  the  account  the 
balance  stands.  Its  presence  on  a  balance  sheet  on  the  debit  side 
less  conspicuously  advertises  the  fact  of  loss  —  and  may  some- 
times for  that  reason  mislead  the  uninformed  stockholder. 

The  Effect  of  Profits  on  Values.  In  single  proprietorships  and 
partnerships  it  is  obvious  that  profits  increase  the  proprietors' 
ownership-claims.  It  is  equally  obvious  that  in  a  corporation  the 
undivided  profits,  and  surplus,  do  likewise.  So  far  as  the  values 
shown  on  the  books  for  assets  are  accurate,  the  intrinsic  value 
(not  taking  account  of  the  speculative  future)  of  each  share  of 
stock  is  the  capital  stock,  plus  undivided  profits  and  surpluses, 
divided  by  the  number  of  shares  of  stock  issued  (or  the  capital 
stock,  less  deficit,  divided  by  the  number  of  shares) ;  for  all  the 
net  assets  belong  to  all  the  stockholders.  Profits,  then,  add  to 
the  value  of  stock,  and  losses  depress  the  value.  When  a  partner 
withdraws  his  profits,  his  balance  is  of  course  reduced.  So  when  a 
corporation  pays  dividends,  the  value  of  its  shares  is  reduced,  for 
the  profits  previously  appertaining  to  each  share  are  thereby  with- 
drawn. This  is  not  only  theoretically  true  but  practically,  for 
provision  for  dividends  is  accompanied  on  the  market  by  a  decline 
in  the  price  of  shares  equivalent  approximately  to  the  amount  of 
the  dividend;  and  the  degree  of  approximation  depends  upon  the 
absence  of  psychological  elements  connected  with  the  dividend 


'     SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     269 

(such  as  the  fear  of  a  lower  dividend  next  time).  This  decline  in 
price  occurs  usually  subsequent  to  the  declaration  of  dividends 
and  on  the  day  on  which  transfers  of  stock  between  individuals 
cease  for  the  period.  A  large  corporation  must  have  a  period  of 
time  within  which  no  transfer  of  stock  will  be  recognized,  of 
course,  for  it  must  know  to  whom  dividends  are  to  be  paid,  and  it 
cannot  safely  make  pa3anent  if  constant  changes  and  corrections 
are  called  for.  Consequently  for  a  certain  period  after  every 
declaration  of  dividend  the  transfer  books  are  closed  for  transfers. 
Persons  buyiQg  stock  before  the  transfer  books  are  closed  are  en- 
titled to  receive  the  dividend,  and  persons  buying  afterward 
must  wait  for  the  next  dividend,  or,  as  it  is  called,  buy  ^'ex  divi- 
dend." On  the  day  when  transfers  close,  therefore,  the  price 
drops.  Sometimes,  on  the  other  hand,  on  the  day  on  which  a 
declaration  of  dividend  is  annoimced  the  stock  may  rise  sharply; 
for  the  annoimcement  of  larger  earnings  than  had  been  expected 
stimulates  demand  for  the  stock.  The  declaration  of  dividends 
cannot  create  value,  but  it  may  disclose  value;  and  the  announce- 
ment that  dividends  are  to  be  paid  may  psychologically  cause 
stocks  to  rise  in  value  even  when  the  amount  of  earnings  was  pre- 
viously known,  for,  on  the  groimd  that  a  bird  in  the  hand  is  worth 
two  in  the  bush,  some  people  had  rather  have  their  profits  in  cash 
than  left  in  the  hands  of  the  company  as  additional  capital.  As  a 
matter  of  fact,  many  psychological  elements  affect  stock  values, 
but  none  of  them  affect  accounts  until  they  enter  into  transac- 
tions. The  market  value  of  a  stock  is  dependent  on  several 
things,  chiefly  the  following:  the  soundness  of  its  assets,  as  a  basis 
for  settlement  with  stockholders  in  case  of  dissolution;  its  current 
earnings,  as  a  basis  for  dividends;  the  probability  of  future  earn- 
ings, as  a  basis  for  future  return  on  present  investment;  the  atti- 
tude of  the  buying  public  toward  this  particular  stock,  as  a  basis 
for  determining  how  readily  the  investment  can  be  turned  into 
cash  in  case  of  hasty  need  for  ready  money.  Only  the  first  two  are 
matters  that  accounts  can  show.  The  third  is  a  matter  of  judg- 
ment and  prophecy.    The  last  is  largely  psychological. 

Increase  of  Capital  from  Profits.  If  assets  derived  from  profits 
are  distributed  as  dividends,  and  then  the  cash  paid  out  as  divi- 
dends is  received  back  by  the  corporation  from  the  stockholders 


270  THE  FUNDAMENTALS  OF  ACCOUNTING 

as  investment  covered  by  new  stock  issued,  it  is  clear  that  the 
capital  of  the  corporation  has  been  increased  over  what  it  was  be- 
fore the  profits  were  earned,  for  the  profits  are  still  in  the  busi- 
ness. It  is  equally  clear  that  if  the  assets  derived  from  profits 
had  never  been  distributed  at  all,  the  condition  would  have  been 
virtually  the  same:  the  earned  assets  would  be  in  the  business 
just  the  same,  but  there  would  have  been  no  dividends,  no  cash 
handled,  and  no  new  capital  stock;  and  so  the  dividends  make  no 
difference  to  any  one  if  the  amount  received  is  immediately  re- 
turned to  the  company  as  investment,  and  the  capital  stock 
though  increased  in  amount  for  each  stockholder  represents  no 
more  assets  than  before  and  hence  is  worth  no  more  in  the  larger 
amoimt  than  in  the  smaller.  The  increase  in  the  number  of  shares 
reduces  the  value  of  each  share.  This  does  not  mean  that  a  share 
of  stock  is  worth  less  than  it  was  at  the  beginning  of  the  earning 
period,  but  less  than  it  was  at  the  end  of  that  period:  if  the  shares 
issued  exactly  equal  in  par  value  the  dividends  paid  and  returned, 
the  increase  in  assets  (from  profits)  during  the  period  is  exactly 
matched  by  the  increase  in  par  value  of  shares  issued,  and  the 
value  per  share  is  thus  not  affected;  but  before  the  dividend  was 
declared  the  profits  were  covered  by  the  ownership  of  old  shares, 
adding  just  so  much  proportionately  to  the  value  of  each,  and 
hence  the  issue  of  new  shares  brings  back  the  value  of  each  share 
to  what  it  was  at  the  beginning  of  the  period,  and  thus  reduces  it 
below  what  it  was  at  the  end  of  the  period  before  the  dividend  was 
declared.  In  other  words,  in  essential  features  the  situation  is 
the  same  as  before  the  dividend  was  declared,  but  in  nominal 
features  it  is  changed,  for  dividends  and  new  stock  have  appeared. 
Sometimes  these  nominal  changes  are  worth  while,  for  people  are 
affected  by  purely  nominal  things.  For  a  corporation  to  omit  an 
expected  dividend  often  has  a  depressing  effect  both  upon  its 
credit  and  upon  the  market  value  of  its  stock,  even  though  the 
company  is  sounder  and  in  a  better  position  to  earn  profits  by 
omitting  the  dividend.  Business  policy  must  often  take  into 
account  purely  psychological  factors.  On  the  balance  sheet, 
however,  the  only  effect  of  it  all  is  a  substitution  of  an  addition  to 
Capital  Stock  for  the  credit  to  Undivided  Profits  or  Surplus  that 
would  have  appeared  if  the  dividend  had  not  been  declared. 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     2Jl 

Stock  Dividends.  In  the  paragraph  above  we  assumed  cash 
dividends  returned  to  the  company  in  the  form  of  investment 
covered  by  new  stock.  The  net  result  of  it  all  was  merely  a  sub- 
stitution on  the  balance  sheet  of  Capital  Stock  for  Undivided 
Profits  —  for  the  other  accoimts  concerned  were  both  debited  and 
credited  for  the  same  amount  —  Cash,  and  Dividends.  If  this  is 
the  net  result  of  the  transactions,  it  is  obvious  that  a  short  cut 
may  be  taken  —  issuing  the  stock  in  place  of  the  cash,  and  thereby 
avoiding  the  handling  of  cash  and  entries  for  it.  This  constitutes 
a  stock  dividend.    A  simple  entry  takes  care  of  it: 

Undivided  Profits 
To  Capital  Stock 

Or,  if  it  is  desired  to  show  the  dividend  under  its  own  title  in  a 
ledger  account,  the  entries  read 

Undivided  Profits 

To  Stock  Dividend  #i 

Stock  Dividend  #i 
To  Capital  Stock 

As  in  the  case  above,  however,  this  does  not  create  new  assets  nor 
deplete  old.  It  merely  substitutes  proprietors'  ownership-claim 
in  the  form  of  new  stock  certificates  for  a  claim  to  profits  apper- 
taining to  the  old  certificates.  The  new  issue,  merely  increasing 
the  number  of  shares,  depresses  the  value  of  the  old;  so  that  now 
perhaps  50,000  shares  of  stock  cover  $5,000,000  of  assets,  whereas 
before  40,000  shares  covered  those  assets,  or  a  new  value  of 
$100  a  share  succeeds  an  old  value  of  $125  a  share,  and  now  a 
man  has  five  shares  worth  $500  in  place  of  his  old  four  shares 
worth  $500.  So  far  as  it  is  easier  to  sell  shares  at  par  than 
above  par,  as  psychologically  sometimes  it  is,  this  is  an  advan- 
tage to  the  stockholder  who  may  wish  to  change  his  investment, 
and  is  no  loss  to  the  company.  This  is  exactly  what  happens, 
of  course,  when  cash  dividends  are  declared,  as  we  saw  above: 
but  since  stock  dividends  usually  are  declared  not  out  of  profits 
of  the  preceding  period,  as  most  commonly  are  cash  dividends, 
but  out  of  profits  accumulated  over  several  earning  periods,  they 
are  likely  to  be  much  larger  and  the  effect  of  the  stock  dividend 
on  the  market  price  of  the  stock  is  likely  to  be  much  greater. 


272  THE  FUNDAMENTALS  OF  ACCOUNTING 

Stocks  without  Par  Value.  As  we  have  already  seen,  the  sig- 
nificance of  the  par  value  on  stock  is  slight;  yet  it  is  doubtless 
true  that  many  subscribers  or  purchasers  have  thought  some 
sanctity  attached  to  the  "one  hundred  dollars"  appearing  on  the 
face  of  a  stock  certificate,  and  have  been  led  to  pay  more  or  sell 
for  less  than  otherwise.  In  some  States  the  inabiHty  to  sell  stock 
at  a  discount  has  led  to  awkwardness,  to  misunderstanding,  and 
even  to  temptation.  One  device  recently  adopted  in  the  hope  of 
eliminating  these  difficulties  is  the  issue  of  stock  certificates  with- 
out par  value.  These,  of  course,  certify  merely  that  the  owner  of 
the  certificate  is  a  part  owner  in  the  enterprise,  and  is  entitled  to  a 
certain  proportion  of  its  declared  dividends  and  in  case  of  dissolu- 
tion to  a  certain  proportion  of  its  net  assets.  Since  no  named 
value  is  attached  to  the  certificate,  no  discount  or  premium  is 
recognizable,  for  there  is  nothing  with  which  to  compare  the 
amount  invested  in  the  company  and  covered  by  the  certificate. 
In  other  words,  the  company  may  issue  shares  at  whatever  it  can 
induce  people  to  invest  upon  them,  but  of  course  it  must  take 
every  precaution  that  all  persons  shall  make  the  same  investment 
for  the  same  number  of  shares  —  except  so  far  as  conditions  have 
changed  between  the  times  of  investment.  The  entry  for  issue  of 
shares  by  companies  issuing  only  shares  without  par  value  is  con- 
veniently 

Assets  (cash  or  what-not) 
To  Invested  Capital 

and  the  amount  should  be  the  actual  value  of  the  property  in- 
vested. It  is  preferable  not  to  use  the  term  Capital  Stock,  for 
this  should  be  confined  to  the  books  of  businesses  having  stock 
with  a  par  value  (simply  to  avoid  confusion).  From  this  point 
on,  the  accounting  for  stocks  with  no  par  value  is  virtually 
identical  with  that  for  par-value  stocks  except  for  items  which 
hinge  upon  a  par  value.  Surplus  is  excess  of  net  assets  above 
investment  rather  than  above  par  of  capital  stock,  and  Deficit 
is  the  measure  of  the  failure  of  net  assets  to  meet  investment. 
Premium  Surplus  and  Discount  on  Stock  then  cannot  be,  for 
there  is  no  such  thing  as  premium  and  discount  on  stock  in  such 
corporations.  If,  however,  the  corporation  issues  one  kind  of  stock 
with  par  value,  say  preferred,  and  another  without,  it  will  necessa- 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     273 

rily  have  an  account  for  capital  stock,  and  then  to  credit  Invested 
Capital  for  the  amount  invested  on  stock  without  par  value  would 
be  misleading,  for  it  would  suggest  that  the  total  invested  capital 
was  covered  by  it.  In  this  case  the  term  "  stock  "  had  best  be  kept, 
and  the  credit  at  issue  may  well  be  to  *' Stock  of  No-Par  Value." 
Bonds.  One  type  of  obHgation  issued  by  corporations  and  not 
usually  by  private  proprietorships  is  bonds.  These  are  virtually 
only  promissory  notes  rimning  for  a  long  term,  but  they  com- 
monly have  mortgage  features  attached.  Since  often  they  run  for 
many  years  before  maturity,  it  is  natural  that  they  should  be 
issued  by  corporations  which  have  a  long  or  perpetual  charter. 
The  accounting  principles  involved  in  both  bond  issue  and  bond 
holding  will  be  discussed  in  Chapter  XX. 

QUESTIONS  AND  PROBLEMS 

1.  Show  the  entries  for  the  following  transactions: 

(a)  $50,000  of  capital  stock  is  subscribed  for  in  two  installments, 
60%  and  40%  respectively. 

(b)  $30,000  of  stock  subscriptions  are  paid  in  cash. 

(c)  $40,000  more  of  capital  stock  is  subscribed  for  at  par. 

(d)  $60,000  in  cash  is  paid  on  stock  subscriptions. 

(e)  Stockholders  donate  to  the  corporation  $15,000  of  stock  of  the 
corporation. 

(f)  The  donated  stock  is  sold  at  80. 
Show  the  balance  sheet  at  the  end. 

2.  A  corporation  is  authorized  to  issue  $50,000  of  new  stock 

$30,000  of  stock  is  subscribed  for  in  three  installments  of  $10,000. 
An  additional  $20,000  of  stock  is  subscribed  for. 
Installments  #1,  #2,  #3  are  paid,  #1  and  #3  in  cash,  §2  in  services. 
The  last  subscriptions  are  paid  in  cash. 
The  stock  is  issued  when  paid  for  in  full. 

Stock  of  par  value  of  $io,ooais  returned  to  the  corporation  as  a  gift. 
It  is  then  sold  for  $11,000. 
Show  entries  for  these  transactions,  with  the  balance  sheet  at  the  end. 

3.  A  corporation  is  organized  to  take  over  and  expand  an  old  business. 

It  receives  from  the  incorporators  subscriptions  for  $10,000  of  stock 
at  par,  collects  the  cash,  and  issues  the  stock. 

It  then  buys  the  old  business,  of  which  the  balance  sheet  is  shown  be- 
low. 

Plant,  etc.                       $50,000  Proprietor  A  $33,000 

Accounts  Receivable         18,000  Proprietor  B  33,000 

Merchandise                    16,000  Accounts  Payable  18,000 

$84,000  $84,000 


74  THE  FUNDAMENTALS  OF  ACCOUNTING 

It  finds  that  the  assets  are  worth  the  figure  at  which  they  stand  on 
the  resource  side  of  the  balance  sheet.  It  takes  over  the  business,  in- 
cluding both  assets  and  liabilities,  and  gives  the  old  proprietors  for 
their  interests  stock  in  the  corporation  having  a  par  value  of  $84,000. 

The  new  corporation  now  receives  subscriptions  for  $100,000  par 
of  stock  at  no  in  two  equal  installments,  and  collects  the  first  install- 
ment. 

All  these  transactions  occur  on  the  same  day,  by  prearrangement, 
and  after  them  at  a  meeting  of  the  directors  the  treasurer  submits  a 
balance  sheet  as  follows: 


Plant,  etc. 

$68,000 

Capital  Stock 

$204,000 

Accounts  Receivable 

73,000 

Accounts  Payable 

18,000 

Merchandise 

16,000 

Cash 

65,000 

$222,000  $222,000 

(a)  If  you  accept  the  treasurer's  figures,  explain  them  by  showing 
the  journal  entries  that  gave  rise  to  them.  If  you  do  not  accept 
them,  show  your  own  balance  sheet  and  the  entries  that  estab- 
lished it. 

(b)  Now  imagine  yourself  to  be  in  charge  of  the  books  of  the  old 
firm,  and  show  journal  entries  for  finally  closing  them,  supposing 
A  and  B  to  be  equal  partners  in  all  respects. 

A  corporation  is  authorized  to  issue  $300,000  of  preferred  stock  and  3 ,000 
shares  of  common  stock  of  no  par  value. 

The  preferred  stock  is  subscribed  for  at  $360,000,  payable  in  three 
equal  installments. 

Two  thousand  shares  of  common  stock  are  subscribed  for  at  $50  a 
share. 

Installment  #1  is  paid  in  cash.    One  thousand  shares  of  coromon  stock 
are  subscribed  for  at  $50. 

Installment  #2  is  paid  in  cash.    The  conmion  shares  are  paid  for  in 
cash  and  are  issued. 

Installment  #3  is  paid  in  cash.    The  preferred  stock  is  issued. 

Show  in  journal  form  the  necessary  entries. 
A  corporation  has  stock  issued  as  follows:  ist  preferred,  $1,000,000 
[par  value  $100];  2d  preferred,  $500,000  [par  value  $50];  common, 
5,000  shares  [no  par  value].  The  dividends  called  for  by  the  ist  pre- 
ferred shares  are  3^%  semi-annually,  and  by  the  2d  preferred  shares 
3%  semi-annually.  The  earnings  available  for  dividends  for  a  half-year 
are  $105,000.  The  regular  dividends  are  declared  on  ist  and  2d  pre- 
ferred shares.  Out  of  the  balance  of  earnings  a  dividend  of  $1.50  per 
share  is  declared  on  the  common  stock,  and  the  remainder  of  the  earn- 
ings is  added  to  surplus.  Out  of  the  surplus  a  stock  dividend  of  one 
share  of  2d  preferred  stock  is  declared  to  each  holder  of  one  share  of 
common  stock.  The  cash  dividends  are  paid,  and  the  stock  dividend 
is  issued. 


SOME  PECULIARITIES  OF  CORPORATION  ACCOUNTS     275 

Show  journal  entries  for  all  transactions  connected  with  the  declara- 
tion and  payment  of  dividends  and  the  issue  of  the  new  preferred  stock. 
6.  A  solvent  corporation  has  voted  to  dissolve.    Its  assets  have  been  sold 
and  its  liabilities  satisfied.    The  balance  sheet  shows  only  cash  and  the 
claims  of  the  stockholders. 

Cash 


$1,244,000 

ist  Preferred  Stock 

$100,000 

2d  Preferred  Stock 

750,000 

Common  Stock 

250,000 

Surplus 

4,000 

Premium  Surplus 

140,000 

$1,244,000 

$1,244,000 

The  preferred  stock  has  a  par  of  $100,  but  the  common  stock,  5,000 
shares,  has  no  par  value.  By  the  agreement  for  dissolution,  holders 
of  first  preferred  stock  are  to  receive  $115  a  share,  and  holders  of 
second  preferred  are  to  receive  $109  a  share.  The  expenses  of  dis- 
solution are  $11,500. 

Show  in  journal  form  the  entries  for  dissolution  and  for  closing  the 
books. 

At  the  middle  of  the  manufacturing  season  it  is  found  that  only  enough 
goods  can  be  finished  and  converted  into  cash  to  pay,  with  the  cash  now 
on  hand,  wages  and  current  items  until  the  end  of  the  season;  yet  re- 
placement of  worn-out  equipment  is  needed.  In  this  strait,  one  of  the 
partners  suggests  removing  the  pledge  of  inviolability  from  the  surplus 
and  using  that  to  pay  for  replacement.  How  far  is  this  suggestion 
feasible  if  the  other  partners  agree? 


CHAPTER  XVII 

WHERE  DO  PROFITS  BEGIN? 

What  are  Costs?  It  is  common  to  read  of  some  farmer  who  at  a 
restaurant  makes  criticism  of  the  high  prices  and  tells  of  the  mar- 
gin of  profit;  for  he  knows  what  he  as  a  producer  receives  for  the 
product  served  in  the  restaurant.  One  may  criticize  such  criti- 
cism and  yet  not  go  far  in  defense  of  the  restaurateur.  Very 
few  people  are  competent  to  determine  profits,  for  few  are  com- 
petent to  determine  where  profits  begin.  The  difficulty  is  in 
finding  what  is  not  profits.  It  is  easy  to  say  that  profits  consist 
of  all  the  return  in  excess  of  costs;  but  this  leaves  us  to  find  what 
we  mean  by  costs.  We  shall  later  discuss  briefly  the  methods  of 
finding  the  costs  of  specific  articles,  but  here  we  are  concerned 
with  the  general  question  of  what  we  mean  by  costs.  Does  cost 
mean  what  we  have  actually  put  into  the  product,  or  what  we 
should  have  to  spend  now  in  order  to  be  back  where  we  were  be- 
fore we  made  or  bought  the  product?  Does  it  include  things  that 
were  not  incurred  for  this  product  but  for  something  else,  yet  of 
which  this  product  got  the  benefit,  even  though  the  cost  or  con- 
sumption of  the  things  would  have  been  just  as  great  if  this  prod- 
uct had  never  been  made? 

Vagueness  of  **  Cost."  The  word  "cost,"  Kke  many  other 
economic  and  accounting  terms,  has  several  meanings,  and  we 
cannot  go  far  in  a  study  of  costs  without  something  approaching  a 
definition.  The  term  is  used  sometimes  for  loss,  sometimes  for 
what  is  given  up  out  of  what  one  has,  and  sometimes  for  that  of 
which  one  gives  up  a  possibility  though  one  never  gave  up  the 
thing  itself  (because  one  never  had  it  to  give  up).  Economists 
say,  for  example,  that  economic  rent  does  not  enter  into  the  cost 
of  production,  for  such  rent  is  paid  for  the  use  of  a  superior  pro- 
ductive agent,  and  one  gets  back  in  extra  production  what  one 
pays  in  rent;  so  that  the  rent  really  costs  nothing  —  the  extra 
return  is  equal  to  the  extra  payment,  like  the  exchange  of  a  five- 
dollar  bill  for  five  one-dollar  bills.  This  is  a  perfectly  good  use  of 
the  word  "cost";  and  if  rent  is  not  cost  because  the  outlay 


WHERE  DO  PROFITS  BEGIN?  277 

comes  back  in  the  product,  what  the  economists  are  really  talk- 
ing about  in  this  case  is  "cost  as  unreturned  outlay";  but  this 
clearly  is  not  cost  in  the  accounting  sense;  for  we  have  already 
seen  from  our  study  of  the  operating  statement  that  we  should 
lose  much  necessary  statistical  information  if  we  allowed  outgo 
and  income  to  be  cancelled  against  each  other  without  record  of 
each  separately.  Everybody  says  that  wages  paid  are  a  cost  of 
doing  business  —  for  cash  is  given  up  in  getting  the  new  things; 
and  this  is  an  accounting  sense  of  "cost/'  which  we  may  call 
"cost  as  outlay."  Economists  say  that  if  we  use  our  capital  in 
our  own  business  the  interest  that  we  might  have  received  on  it 
by  lending  it  is  a  cost  of  conducting  our  own  business.  This  we 
may  call  "cost  as  abstinence."  Much  difference  of  opinion  is 
foujid  among  accountants  about  this  sort  of  cost,  but  it  is  due  to 
different  points  of  view  with  respect  to  the  meaning,  or  the  desira- 
ble meaning,  of  "cost"  and  "profits."  With  the  first  of  the 
meanings  of  cost,  cost  as  unreturned  outlay,  we  have  here  nothing 
to  do;  for  though  it  is  true  that  economic  rent  is  not  a  cost  in  the 
sense  in  which  the  term  is  used  in  that  connection,  it  is  a  cost  in 
the  second  sense,  "cost  as  outlay,"  which  we  are  now  about  to 
examine.  The  third  sense,  "  cost  as  abstinence,"  we  shall  exam- 
ine later,  in  connection  with  the  finding  of  costs  for  specific  arti- 
cles of  product. 

Independence  of  Cost  and  Selling  Price.  The  first  step  in  an 
understanding  of  profits  is  a  realization  of  the  independence  of 
cost  and  selling  price.  It  is  true  that  in  the  long  run  selling  price 
must  equal  cost  plus  a  margin  of  profit,  else  goods  will  not  be  pro- 
duced and  sold,  and  services  will  not  be  rendered.  It  is  also  true 
that  selling  price  will  affect  costs  in  some  instances,  for  the  price 
does  sometimes  affect  efficiency,  leading  to  greater  economy  when 
the  price  is  low  and  greater  carelessness  when  the  price  is  high. 
With  these  exceptions,  however,  cost  and  price  are  for  any  particu- 
lar business  man  at  a  particular  time  determined  by  independent 
transactions  with  unrelated  elements  of  business  society.  The 
fact  that  a  selling  price  is  so  high  that  the  product  "can  stand" 
heavy  costs,  and  that  other  prices  are  so  low  that  other  products 
"cannot  stand"  heavy  costs,  has  nothing  to  do  with  the  facts  of 
cost.    Cost  has  to  do  with  the  hard  facts  of  reality  in  producing 


278  THE  FUNDAMENTALS  OF  ACCOUNTING 

goods  and  rendering  services,  and  comes  from  dealing  with  certain 
groups  of  people  and  circumstances,  and  usually  it  has  nothing  to 
do  with  what  is  to  be  received  for  the  goods  or  services  after  they 
have  been  produced  or  rendered,  in  dealing  with  other  groups  of 
people  and  circumstances.  Accounting  has  to  do  with  the  truth, 
the  whole  truth,  and  nothing  but  the  truth;  and  it  must  not  be 
affected  by  one's  wishes,  or  prejudices,  or  notions  of  how  things 
would  have  been  if  they  had  been  different.  The  problem  of  ac- 
counting is  to  show  how  things  actually  are.  Many  times  it  is 
difficult  to  know  how  things  are,  for  circumstances  are  so  complex, 
and  data  are  so  inadequate,  that  the  conditions  defy  complete 
analysis  —  as  often,  for  illustration,  with  the  actual  amount  of 
depreciation  on  a  building;  but  the  best  available  knowledge  of 
costs  should  always  be  utilized  independently  of  extraneous  cir- 
cumstances. It  is  the  height  of  accounting  misrepresentation  to 
charge  one  thing  more  than  another  for  costs  merely  because  it 
chances  to  have  a  higher  selling  price:  the  purpose  of  accounting 
is  in  part  to  show  the  difference  between  cost  and  selling  price, 
and  if  we  allow  the  selling  price  arbitrarily  to  affect  the  figuring 
of  costs  we  are  destrojdng  in  that  process  the  possibility  of  doing 
well  one  of  the  very  things  we  set  out  to  do. 

Independence  of  Cost  and  Replacement.  The  second  principle 
necessary  to  an  understanding  of  profits  is  that  cost  has  nothing 
to  do  with  circumstances  unrelated  to  the  particular  business 
and  particular  transactions  concerned.  If  I  pay  $5,000  for  a  bit  of 
property  and  sell  it  for  $7,000  without  incidental  costs,  my  profit 
is  $2,000;  and  the  fact  that  I  later  buy  another  bit  of  property, 
like  that  sold,  for  $4,000,  does  not  affect  my  profit.  It  is  true 
that  I  now  have  $3,000  more  cash  than  after  I  bought  the  first 
property  ($7,000  selling  price  less  $4,000  paid  for  the  new  article) ; 
but  of  this  $3,000,  $2,000  is  profit  on  the  first  article  and  $1,000  is 
original  capital  returned  to  me  from  the  sale  and  now  set  free  by 
the  fact  that  I  can  buy  a  new  article  $1,000  cheaper  than  the  old. 
Similarly,  if  a  new  article  should  cost  $6,000,  my  profits  on  the 
old,  bought  at  $5,000  and  sold  at  $7,000,  would  not  be  thereby 
reduced  to  $1,000:  the  fact  would  be  simply  that  to  continue  in 
business  of  that  sort  I  should  require  more  capital.  A  less  simple 
case,  however,  is  worth  fmrther  study.    Suppose  we  buy  equip- 


WHERE  DO  PROFITS  BEGIN?  279 

ment  worth  $io,cxx)  that  will  serve  for  10  years,  producing  1,000 
articles  a  year.  We  may  say,  then,  that  each  article  produced 
should  be  charged  one  dollar  for  its  share  of  the  depreciation  of  the 
equipment.  If  the  product  sells  for  a  price  (including  a  reason- 
able profit)  that  will  cover  this  one  dollar  charge  along  with  the 
other  costs,  the  business  has  recouped  itself  for  the  outlay  in  this 
particular.  This  is  still  true  even  if  the  cost  of  new  equipment, 
which  this  business  did  not  then  need  to  buy,  suddenly  rose  a 
year  after  the  old  was  bought  to  $15,000;  for  the  $10,000  actu- 
ally invested  is  restored.  The  purchase  of  new  equipment  for 
$15,000  after  the  old  is  worn  out  cannot  affect  costs  of  nine  years 
ago  or  of  nine  days  ago.  The  two  sets  of  equipment  have  them- 
selves independent  costs,  and  the  cost  of  the  product  of  one  has 
nothing  to  do  with  the  cost  of  the  product  of  the  other.  When 
confusion  arises  in  this  particular,  the  cause  is  found  usually  in  a 
failure  sufficiently  to  separate  cost  and  selling  price,  as  suggested 
in  the  preceding  paragraph.  When  we  come  to  the  question  of 
the  justice  of  charges  to  the  customers,  we  step  into  a  new  field  — 
a  field,  moreover,  with  which  in  a  sense  the  accountant  as  such 
has  nothing  to  do;  but  since,  unfortunately,  many  persons  have 
confused  the  two  fields,  it  is  well  to  observe  the  second  here.  As 
soon  as  the  market  price  of  equipment  rises,  the  customer  is  get- 
ting the  product  of  a  higher-priced  means  of  production,  and, 
since  we  usually  consider  that  one  should  pay  for  what  one  is  get- 
ting, he  should  pay  for  the  product  of  the  now  high-priced  equip- 
ment. It  is  true  that  since  the  producer's  cost  has  not  risen,  this 
gives  the  producer  more  profit;  and  this  looks  like  exploiting  the 
customer.  The  results  of  the  chances  of  business,  however,  be- 
long to  those  who  take  the  risks  —  gain  when  things  are  favora- 
ble, loss  when  they  go  wrong.  If  the  market  price  of  equipment 
had  gone  down,  what  would  the  customer  expect?  He  would 
expect,  would  indeed  demand  if  he  had  any  means  of  enforcement, 
that  prices  be  lowered.  Then  the  producer  who  had  bought  his 
equipment  at  the  old  high  level  of  prices  would  suffer  loss.  If  he 
is  to  suffer  the  loss  when  prices  go  down,  he  must  be  allowed  to 
reap  the  gain  when  prices  go  up.  It  should  be  noted  here  that 
under  these  conditions  the  margin  of  profit  will  be  large  to  the 
man  who  bought  his  equipment  at  the  old  price  just  before  the 


280  THE  FUNDAMENTALS  OF  ACCOUNTING 

price  went  up,  for  he  will  have  a  long  term  of  reaping  large  profits; 
but  he  will  lose  that  again  if  he  chances  to  renew  his  equipment  at 
high  prices  just  before  they  fall  again.  There  is,  then,  no  ques- 
tion of  justice  involved  in  the  exclusion  of  replacement  from  costs; 
for  if  the  customer  ought  to  pay  for  replacement,  that  is  a  matter 
of  selling  price  only:  cost  is  a  matter  of  historical  fact  with  which 
neither  selling  price  nor  replacement  has  anything  to  do. 

Cost  as  Outlay.  It  is  clear  that  cost  is  concerned  with  the 
acquisition  of  property  or  services,  for  when  we  speak  of  costs  we 
have  in  mind  something  acquired  —  either  property  acquired,  or 
services  rendered  to  us  or  on  our  behalf  to  some  one  else;  but  the 
measure  of  cost  is  always  the  complement  of  the  thing  acquired  — 
namely,  the  thing  given.  It  is  clear  from  the  preceding  discus- 
sion, too,  that  cost  is  a  matter  of  past  or  present,  not  of  the  future. 
Except,  of  course,  when  the  transaction  is  inextricably  a  part  of 
a  large  whole,  such  as  the  ten-year  life  of  the  machine  mentioned 
above,  cost  has  nothing  to  do  with  the  future  of  the  property  or 
service  acquired,  with  either  its  disposition  or  its  replacement. 
The  common  errors  in  determining  costs  lie  in  three  directions: 
forgetting  the  simple  facts  just  stated,  neglecting  to  see  all  the 
value  given,  failing  to  observe  just  what  was  got  for  what  was 
given.  If  one  acquires  property  by  simple  exchange,  the  cost  is 
obvious.  If  I  give  five  dollars  to  a  book  agent  for  a  book  that  he 
brings  to  my  house,  the  cost  of  the  book  is  obviously  five  dollars. 
As  we  have  seen,  however,  a  large  part  of  business  consists  of 
something  else  than  simple  exchange.  Conversion  of  assets  is 
involved  —  for  even  simple  sales  usually  involve  salesmen  and 
other  selling  expenses,  and  the  assets  which  pay  for  the  contribu- 
tory things  thereby  become  converted  into  the  ultimate  thing  got. 
If,  for  example,  I  buy  a  factory  site  for  five  thousand  dollars,  the 
actual  cost  of  the  lot  may  be  much  more;  for  I  may  have  paid  a 
surveyor  twenty  dollars  for  a  survey,  a  lawyer  a  hundred  dollars 
for  passing  upon  the  title  and  the  deed,  and  the  Register  of  Deeds 
two  dollars  for  registry,  and  stamp  taxes  may  amount  to  several 
dollars,  and  traveling  expenses  and  postage  and  telephone  calls  in 
connection  with  the  completion  of  the  purchase  may  amount  to 
many  dollars,  to  say  nothing  of  the  pay  of  clerks  copying  docu- 
ments, etc.    Some  of  these  things,  it  should  be  remarked,  have 


WHERE  DO  PROFITS  BEGIN?  28 1 

nothing  to  do  with  the  actual  value  of  the  lot:  they  are  incidental 
to  my  purchase  of  the  lot,  and  the  lot  would  probably  be  worth 
just  as  much  if  I  had  never  heard  of  its  existence;  but  for  my  pos- 
session of  the  lot  they  are  costs.  This  has  been  expressed  briefly 
in  bookkeeping  form  in  Chapter  VII  through  Converted  Assets, 
which  was  debited  for  all  the  costs  going  into  the  goods  sold.  The 
credit  side  of  this  accoimt,  of  course,  has  nothing  to  do  with  costs. 
The  debits  are  typical  of  costs,  and  from  them  we  may  develop 
our  principle.  They  included  the  following  t5rpical  items:  wages 
and  rent,  for  cash  payment  for  services  which,  though  they 
brought  their  equivalent  in  value,  did  not  appear  on  the  ledger 
imder  the  title  of  the  actual  asset  obtained  from  them;  reductions 
in  value,  like  fuel  consimiption  and  expiration  of  insurance  pre- 
paid ;  and  royalties,  for  royalty  liability  incurred.  In  other  words, 
all  of  them  involved  some  type  of  disappearance  of  value  —  en- 
tire disappearance  of  value,  partial  disappearance  of  value,  or  the 
setting  up  of  a  liability  (which  is  the  same  thing  as  a  disappear- 
ance of  value,  for  value  will  disappear  in  meeting  it).  This,  in- 
deed, is  what  we  mean,  in  the  accounting  sense,  by  cost  —  disap- 
pearance of  value  in  the  acquisition  of  other  value.  Sometimes 
the  disappearance  is  due  to  mere  exchange  of  values,  and  some- 
times to  conversion  of  values.  The  books  show  what  values  have 
disappeared,  and  what  values  have  appeared;  but  only  the  former 
are  costs  —  they  are  the  costs  of  obtaining  the  latter.  Yet  if  we 
are  careless  in  showing  the  values  that  have  appeared,  the  yield 
from  the  costs,  we  shall  have  misrepresented  that  to  which  the 
costs  apply,  and  our  conclusion  will  err  as  badly  as  if  the  costs 
themselves  had  been  misrepresented. 

Finding  the  Costs.  The  disappearances  of  value  which  consti- 
tute cost  are  much  more  numerous  and  much  less  obvious  than 
the  iminitiated  are  likely  to  suspect,  and  sometimes  finding  the 
relation  between  the  returns  from  costs  and  the  costs  which  pro- 
duced the  returns  is  so  difficult  that  long  experience  is  essential  to 
successful  cost  accoimting.  For  this  reason  no  attempt  will  be 
made  here  to  discuss  the  matter  fully.  Such  discussion  of  method 
as  is  feasible  in  this  book  is  given  in  Chapter  XXII.  It  is  worth 
while  here,  however,  to  note  at  least  one  illustration  of  the  variety 
of  elements  entering  into  the  cost  of  a  simple  article,  thus  getting  a 


282  THE  FUNDAMENTALS  OF  ACCOUNTING 

hint  of  the  reason  why  finding  costs  is  not  a  matter  of  hasty  ob- 
servation—  usually  because  many  of  the  costs  are  not  visibly 
connected  with  the  final  product.  Let  us  revert  to  our  illustration 
at  the  beginning  of  this  chapter,  food  served  at  a  restaurant. 
The  obvious  things  of  which  the  farmer  was  doubtless  thinking 
were  the  cost  of  the  raw  food,  the  fuel  for  cooking  it,  and  the 
wages  of  cooks.  Let  us  add  a  few  only  of  the  other  items  (for  the 
complete  Hst  would  cover  several  pages  of  text  and  sadly  bore  the 
reader) .  Connected  with  the  raw  food,  we  find  the  cost  of  buying 
(including  clerical  help,  postage,  and  stationery),  freight  and 
cartage,  receiving  and  sampling  and  checking  the  goods  with  the 
invoices,  doing  the  bookkeeping  for  purchases,  correspondence 
regarding  purchases  and  payment,  storing,  refrigeration,  loss  by 
spoilage  of  food  ready  for  d  la  carte  service  but  not  demanded,  in- 
surance on  goods  in  storage,  rent  and  Hght  and  care  of  storerooms, 
and  selecting  required  foods  from  the  storeroom  for  use.  Con- 
nected with  the  preparation  of  food  we  may  have  purchase,  stor- 
age, and  handling  of  fuel;  insurance,  taxes,  and  depreciation  of 
cooking  ranges  and  utensils;  rent,  light,  and  heat  of  kitchens; 
spoilage,  waste,  and  petty  thieving;  cleaning  of  utensils  and  care 
of  kitchen.  Connected  with  the  serving  room  we  have  almost 
all  the  costs  of  the  kitchen  repeated.  Connected  with  the  din- 
ing room  we  may  have  not  only  waiters'  but  checkers'  and  cash- 
iers' wages;  insurance,  taxes,  and  depreciation  of  table  linen,  of 
china,  of  silver,  of  glass,  and  of  furniture;  rent,  often  very  high, 
Kght  in  abundance,  heat;  printing  of  menus;  floral  and  other 
decorations.  To  find  how  much  of  all  these  costs,  together  with 
those  not  named  above,  is  chargeable  to  a  plate  of  toast  and  how 
much  to  a  broiled  chicken  is  a  problem  beyond  the  scope  of  book- 
keeping. To  solve  it  exactly  we  should  have  to  determine  how 
much  of  each  of  these  costs  contributed  to  the  toast  as  served  and 
how  much  of  each  to  the  chicken  as  served. 

Division  of  Costs  between  Periods.  The  difficulty  of  attach- 
ing costs,  even  after  they  have  been  foimd  in  total,  to  particular 
parts  of  product  (as  we  did  by  the  cost-accounting  method  of 
Chapter  VI  but  could  not  do  by  the  inventory  method  of  Chapter 
VII)  is  found  sometimes  to  apply  to  a  division  of  costs  between 
periods.    Suppose,  for  example,  that  a  machine  costing  $10,000  is 


WHERE  DO  PROFITS  BEGIN?  283 

judged  good  for  ten  years*  use,  and  that  its  loss  of  value  at  that 
time  will  be  due  to  wear.  Suppose,  too,  to  make  our  illustration 
simple,  that  the  estimate  of  ten  years'  life  is  correct.  Suppose, 
lastly,  that  the  product  of  the  machine  is  10,000  articles  in  the 
first  year,  14,000  in  the  second,  and  12,000  in  each  of  the  remain- 
ing years.  What  should  be  the  charge  to  the  product  of  each  year 
for  depreciation  of  the  machine?  A  charge  of  one-tenth  the  total, 
or  $1 ,000  per  year,  is  easily  made  to  Converted  Assets,  or  Loss  and 
Gain,  with  a  credit  to  Machinery.  This  when  statistically  ap- 
plied to  the  product  of  each  year  gives  a  unit  cost  for  depreciation 
of  10^  ($1,000  4-  10,000)  for  the  first  year,  7.14^^  for  the  second, 
and  Sl^  for  each  of  the  others.  Is  this  correct?  Is  there  any 
actual  difference  in  cost  between  the  depreciation  chargeable  to 
articles  which  happen  to  be  made  in  the  second  year  and  that 
chargeable  to  those  made  in  the  third?  We  have  assumed  here 
depreciation  at  a  constant  rats,  though  we  might  have  assumed, 
as  some  accountants  do,  that  the  machine  depreciates  slowly  at 
first  and  then  rapidly.  Even  assmning  a  constant  rate,  should 
the  rate  be  applied  to  periods  of  time  or  to  articles  of  product? 
If  the  depreciation  is  due  to  wear,  it  is  clearly  assignable  to  prod- 
uct rather  than  to  time,  and  all  articles  produced  in  the  ten  years 
should  be  charged  alike.  Our  120,000  articles  wearing  out  $10,- 
000  worth  of  machinery  should  be  charged  8J^  each,  therefore,  in 
whatever  year  they  are  produced.  Difficulty  at  once  arises  here, 
however,  when  we  observe  that  we  found  this  rate  by  knowing  the 
product  for  the  whole  ten  years;  but  we  can't  wait  ten  years  to 
find  our  profits  (and  hence  our  costs)  for  the  first  year.  In  prac- 
tice, therefore,  we  must  either  (i)  use  the  arbitrary  ten  years  and 
take  one- tenth  each  year,  or  (2)  estimate  our  product  for  the  whole 
ten  years,  calculate  the  cost  per  unit  of  product,  and  apply  that  to 
the  product  of  each  year  in  turn  —  adjusting  our  estimate  as  ex- 
perience corrects  it.  The  former  is  simple,  works  out  without 
discrepancy  at  the  end,  and  is  fairly  accurate  when  the  product 
is  fairly  uniform  year  by  year  and  the  estimate  of  the  life  of  the 
machine  is  fairly  accurate.  The  latter  is  more  accurate  if  the 
estimates  are  fairly  accurate,  but  (hinging  upon  two  estimates  to 
the  other's  one)  is  less  accurate  if  the  estimates  are  farther  from 
the  facts  than  the  facts  are  from  uniformity.     Both  methods 


284  THE  FUNDAMENTALS  OF  ACCOUNTING 

show  that  costs  are  not  always  exactly  ascertainable;  for  though 
the  future  cannot  alter  the  facts  of  the  past,  some  things  must  be 
taken  over  large  wholes  and  the  share  which  the  past  has  in  those 
wholes  cannot  be  known  until  the  wholes  are  known.  They  both 
suggest  the  desirability  of  a  reservation  of  supposed  profits  as  a 
sort  of  buffer  to  take  the  shock  of  discovery  that  certain  costs  and 
profits  have  been  miscalculated  and  that  certain  assets  supposed 
to  be  good  have  shrunk  below  the  book  values  (as  when  machin- 
ery has  been  depreciated  75%  and  discovery  is  made  that  90%  is 
none  too  much). 

Cost  and  Inventories  —  Merchandise.  One  of  the  commonest 
tasks  in  connection  with  dividing  costs  and  profits  between  peri- 
ods is  that  of  finding  gross  profits  on  merchandise.  In  many  mer- 
cantile businesses  it  is  not  thought  worth  while  to  attach  the  cost 
of  every  article  sold  to  its  selling  price;  and  therefore  gross  profits 
cannot  be  found  by  the  cost-accounting  method  of  Chapter  VI, 
but  must  be  found  by  the  inventory  method  of  Chapter  VII. 
The  danger  of  error  lies  in  the  method  of  taking  inventory.  The 
purpose  of  taking  inventory  is  in  this  connection  to  learn  what  has 
not  been  sold,  in  order  that  we  may  learn  the  cost  of  what  has 
been  sold  (that  is,  the  disappearance  of  value  through  sales,  in 
acquiring  the  selling  price).  It  is  obvious  that  an  exaggeration  of 
the  inventory  of  what  has  not  been  sold  (which  is  subtracted  from 
the  total  goods  handled)  reduces  the  apparent  cost  of  what  has 
been  sold,  and  so  exaggerates  profits.  Optimism  creates  a  strong 
temptation  to  exaggerate  inventory,  for  it  tends  to  think  the 
goods  worth  more  than  they  are.  A  little  thought  makes  clear 
that  the  inventory  should  never  be  higher  than  cost  however  the 
market  price  may  have  risen,  for  the  goods  have  not  been  sold  and 
hence  cannot  yet  have  yielded  a  profit  —  even  though  they  may 
do  so  in  the  next  period.  No  profit  is  ever  made  on  anything 
while  it  is  held:  the  profit  is  only  imaginary  (so-called  "paper 
profit")  until  the  article  has  been  exchanged  for  something  else  of 
higher  value :  then  the  conversion  or  exchange  has  actually  taken 
place  and  the  profit  is  real.  Since  profit  is  made  only  on  what  is 
sold,  the  inventory  consisting  of  what  has  not  been  sold  cannot 
include  any  profit.  Yet,  though  we  usually  designate  as  poor  a 
rule  that  won't  work  both  ways,  virtually  aU  accountants  are 


WHERE  DO  PROFITS  BEGIN?  285 

agreed  that  inventories  of  merchandise  should  be  taken  at  lower 
than  cost  if  the  market  price  has  fallen  since  purchase.  The 
grounds  for  this  and  the  conditions  under  which  it  is  true  require 
examination. 

Inventories  at  Less  than  Cost.  Hope  springs  eternal  in  the 
human  breast:  a  prospect  of  profit  has  led  to  many  an  extrava- 
gance (both  personal  expenditure  and  capital  investment)  that 
unrealized  profit  could  not  pay  for,  and  to  many  a  bankruptcy. 
One  should  not  only  not  count  the  chickens  before  they  are 
hatched,  but  should  not  assume  that  all  will  Uve,  will  all  be  hen 
chickens,  and  will  all  lay  eggs.  Sensible  conservatism  is  in  most 
cases  sufficient  reason  for  taking  inventories  at  less  than  cost 
when  the  market  price  has  fallen.  Another  reason  often  ap- 
pears, moreover.  Goods  are  usually  bought  for  early  sale  (cer- 
tainly the  tendency  of  modern  economy  in  mercantile  businesses 
is  to  buy  little  and  often  rather  than  much  and  seldom).  Goods 
on  hand  at  the  end  of  an  earning  period  consist  then  of  two  sorts: 
those  intended  for  sale  in  the  last  period  and  left  over;  and  those 
bought  for  future  sale.  We  are  here  faced  with  two  contradictory 
desires.  We  desire  to  show  costs  on  our  books,  but  we  desire  also 
not  to  overstate  profits  —  we  desire  not  to  exaggerate  profits  for 
this  period  even  if  the  exaggeration  will  be  corrected  in  the  next 
period,  for  misunderstanding  or  changes  of  ownership  in  the 
meantime  may  cause  injury  or  injustice.  If  we  carry  our  inven- 
tory at  cost,  above  the  present  market  price  at  which  we  could 
now  buy,  we  have  neglected  the  fact  that  goods  bought  to  be  sold 
in  the  last  period  have  shrunk  in  value  and  that  the  new  period 
should  not  be  asked  to  take  over  by  inheritance  goods  with  a 
handicap  attached.  Since  our  purpose  is  to  determine  the  divi- 
sion of  ultimate  profit  and  loss  between  periods,  we  should  put 
each  period  on  its  own  feet.  The  shrinkage  in  value  of  the  left- 
over stock  is  a  cost  of  the  vain  attempt  to  sell  it  and  is  chargeable 
to  the  period  in  which  it  was  meant  to  be  sold,  and  surely  should 
not  be  thrust  into  a  new  period  which  would  be  handicapped  by  it. 
The  new  period  should  be  given  credit,  on  the  other  hand,  for  any 
profit  that  it  may  make  on  the  left-overs  of  the  period  before,  and 
that  profit  is  the  difference  between  the  price  at  which  it  inherits 
fairly  and  its  selling  price  (less  selling  costs).     Stock  purchased 


286  THE  FUNDAMENTALS  OF  ACCOUNTING 

for  sale  in  the  new  period,  on  the  other  hand,  is  chargeable  to  the 
new  period,  and  hence  if  our  accounts  are  to  show  the  historical 
facts,  the  amount  carried  to  the  new  year  should  be  cost.  Then 
the  difference  between  the  actual  cost  and  the  actual  selling  price 
(less  selling  costs)  will  be  shown  on  the  accounts  of  the  new  pe- 
riod, where  in  reality  it  belongs.  As  a  matter  of  fact,  however,  in 
practice  this  division  of  inventory  into  items  bought  for  past  sale 
and  items  bought  for  future  sale  is  not  made,  but  for  the  sake  of 
conservatism  all  are  usually  carried  at  *'  cost  or  market,  whichever 
is  lower."  By  cost,  of  course,  we  mean  cost  after  all  discounts 
available  have  been  subtracted,  whether  they  were  actually  taken 
or  not,  for  we  have  observed  that  a  lost  discount  is  not  a  part  of 
the  cost  of  goods  but  a  payment  for  extended  use  of  other  people's 
money. 

Inventories  of  Raw  Material.  The  considerations  of  the  last 
paragraph  have  much  weight  when  applied  to  the  raw  materi- 
als of  manufacture.  If  market  prices  have  fallen  and  we  take 
the  inventory  at  the  reduced  prices,  the  loss  falls  on  the  year 
when  the  prices  declined,  and  the  amount  charged  to  the  product 
of  the  later  year  when  the  material  is  consiuned  in  manufacturing 
will  be  less  than  the  material  actually  cost.  In  other  words,  the 
actual  cost  of  the  goods  manufactured  from  these  raw  materials 
will  be  understated  because  a  part  of  that  cost  was  absorbed  be- 
fore the  material  was  used.  Is  that  desirable?  Do  we  wish  our 
cost  accounts  to  show  what  our  product  actually  cost,  or  what  it 
might  have  cost  if  we  had  bought  materials  differently?  If  we  are 
to  show  actual  cost,  we  must  carry  the  inventory  to  the  balance 
sheet  (and  therefore  to  the  new  period)  at  cost,  even  though  that 
overvalues  (in  respect  to  present  market  price)  some  of  our  prop- 
erty. As  we  shall  see  in  the  following  chapters,  however,  the  bal- 
ance sheet  is  at  best  a  poor  indicator  of  market  values,  and  it  is 
of  doubtful  advantage  to  sacrifice  the  cost  figures,  that  we  can 
perfectly  well  keep,  for  the  attempt  to  show  market  figures  that 
we  cannot  ever  show  well.  It  is  therefore  wise  to  carry  raw  ma- 
terial bought  distinctly  for  future  use  at  cost,  so  that  it  may  get 
into  the  accounts  at  cost  for  the  period  for  which  it  was  purchased, 
and  reduce  the  inventory  of  raw  material  in  case  of  a  decline  in 
the  market  only  when  such  material  has  been  left  over  from  over- 


WHERE  DO  PROFITS  BEGIN?  287 

stocking  —  in  which  case,  of  course,  the  new  period  should  not  be 
made  to  suffer  the  cost  of  the  error. 

Profit  on  Contracts.  Often  uncertainty  arises  as  to  profits  on 
contracts  partly  completed.  In  general,  contracts  affecting 
something  to  be  done  may  be  divided  into  two  classes:  (i)  those 
in  which  the  profit  arises  out  of  superior  knowledge  or  luck  ap- 
plied to  purchase  and  sale,  as  when  I  agree  to  sell,  at  a  price 
higher  than  I  shall  have  to  pay  for  it,  something  that  I  shall  have 
to  buy  from  a  third  party,  and  I  thus  make  the  other  party  to  my 
contract  pay  me  for  my  knowledge  (which  may  be  also  an  ad- 
vantage to  him,  for  otherwise  he  might  pay  even  more  than  he 
will  pay  me) ;  and  (2)  those  in  which  superior  knowledge  is  ap- 
plied to  the  performance  of  certain  work,  as  in  construction,  and 
the  profit  lies  in  the  skill  with  which  the  work  is  done  or  in  the 
good  luck  which  accompanies  the  accomplishment  of  the  task. 
In  the  first  case  the  profit  is  earned  at  the  signing  of  the  contract 
if  the  second  party  to  the  contract  accepts  the  third  party  to  the 
transaction  as  the  party  now  responsible  for  the  fulfillment  of  the 
contract;  and  in  this  case  the  profit  will  be  taken  on  the  books  at 
the  time  of  the  acceptance  of  the  third  party,  for  the  profit  is  not 
even  contingent.  In  the  other  sort  of  case,  however,  the  profit  is 
not  earned  until  the  work  is  done;  for  fire,  strikes,  transportation 
delays,  political  disorders,  unexpected  handicaps  like  bad  weather 
or  quicksands  in  construction  work,  may  almost  at  the  last  mo- 
ment make  profit  impossible  and  turn  into  loss  what  looked  like 
a  safe  margin  of  difference  between  cost  and  selling  price.  The 
moral  is  to  wait:  to  treat  costs  on  such  contracts  as  assets,  for  they 
contribute  just  so  much  (provided  there  has  been  no  waste) 
toward  the  fulfillment  of  the  contract  (but  of  course  not  in  excess 
of  a  share  of  the  total  contract  price  equivalent  to  the  estimated 
portion  of  the  work  done).  Any  balance  is  a  contingent  item  not 
yet  known  as  either  profit  or  loss.  If  dissolution  of  partnership 
occurs  while  such  things  are  pending,  the  retiring  partner  may  of 
course  be  given  his  share  of  the  contingent  profits  after  he  has 
given  a  bond  to  return  the  amount  in  case  the  apparent  profits 
prove  unreal;  but  more  satisfactory  is  an  agreement  that  he  will 
be  given  further  distribution  of  profits  in  case  probable  profits 
on  the  work  already  done  prove  real. 


288  THE  FUNDAMENTALS  OF  ACCOUNTING 

Capital  Losses  as  Costs.  Akin  to,  indeed  virtually  a  part  of, 
the  division  of  costs  between  periods  is  the  accounting  treatment 
of  so-called  losses  of  capital.  Capital  is  any  wealth  devoted  to 
production,  whether  cash  necessary  for  current  payments  or 
assets  of  a  decidedly  long-enduring  type,  like  buildings  and  ma- 
chinery. It  is  common,  however,  to  speak  of  assets  of  the  long- 
enduring  type  as  capital  assets,  for  they  are  expected  not  to  be 
exhausted  in  one  use,  like  raw  material,  supplies,  postage,  and 
other  current  items,  but  to  form  part  of  the  enduring  capital  of 
the  business.  Capital  is  supposed  to  be  consumed  in  operations, 
and  we  have  defined  cost  as  disappearance  of  assets  in  the  acqui- 
sition of  other  assets;  but  sometimes  assets  disappear  not  nor- 
mally but  extraordinarily.  Suppose  a  shipping  company  oper- 
ates a  fleet  of  twenty  vessels  over  regularly  established  routes, 
and  early  in  a  financial  year  loses  a  vessel  before  it  has  had  any 
earnings.  If  the  loss  on  the  vessel  wrecked  (value  less  insurance 
recovered)  exceeds  the  net  earnings  of  the  other  nineteen  vessels 
for  the  year,  has  the  company  made  a  profit  or  suffered  a  loss? 
The  question  might  also  be  put  in  this  form:  must  conversions 
keep  capital  intact  (supposing  none  withdrawn)  before  profit  can 
begin?  As  we  have  already  seen,  a  cost  is  never  merely  a  cost:  it 
is  the  cost  of  something.  Is  the  disappearance  of  a  part  of  the 
value  of  this  vessel  a  cost  of  the  earnings  of  the  fleet  for  this  pe- 
riod? If  so,  the  year  shows  a  loss.  This  is  surely  so  if  the  loss  of 
one  such  vessel  a  year  is  an  expected  incident  of  operations  —  if 
the  loss  of  one  vessel  a  year  is  normal  on  the  average.  If  not,  this 
loss  is  incidental  not  to  a  single  year  but  to  several,  and  should  be 
treated  as  a  cost  of  several  years'  earnings.  To  provide  for  such 
contingencies,  something  should  be  set  aside  every  year  when 
losses  do  not  occur  for  the  restoration  of  capital  in  the  years  when 
they  do  occur.  It  should  be  noted,  too,  that  if  these  losses  are 
natural  to  the  business,  as  they  are  in  the  shipping  business,  for 
insurance  to  full  value  is  not  usually  possible,  a  fair  proportion 
of  such  losses  is  chargeable  to  every  year  (whether  losses  actually 
occur  in  that  year  or  not)  as  a  cost,  and  hence  is  deducted  from 
earnings  before  profits  are  found.  Profits  have  not  been  made 
unless  the  gross  earnings  cover  such  provision  along  with  the 
other  costs.  An  entry  debiting  Insurance  Charges  and  crediting 


WHERE  DO  PROFITS  BEGIN?  289 

Provision  for  Maritime  Hazard,  as  described  in  Chapter  VIII, 
gives  assurance  that  this  fact  is  not  forgotten.  It  indicates  that 
a  part  of  the  assets  will  probably  disappear  later  as  this  year's 
share  of  normal  capital  losses.  This  is  unlike  the  reserve  recom- 
mended on  page  266:  that  is  a  part  of  what  is  believed  to  be 
profits,  but  may  prove  not  to  be  profits;  this  is  beHeved  to  be  a 
necessary  deduction  from  earnings,  and  hence  not  to  be  profits, 
but  may  prove  to  be  unnecessary  or  larger  than  necessary  and 
hence  to  be  profits  after  all.  If,  on  the  other  hand,  no  provi- 
sion has  been  made  in  the  past  for  capital  losses,  when  they  oc- 
cur the  portion  not  belonging  to  the  current  year  as  a  normal 
operating  cost  must  be  taken  out  of  surplus,  entered  as  a  deficit, 
charged  directly  to  partners,  or  carried  as  a  deferred  asset.  The 
only  defense  for  the  last  is  in  case  the  loss  occurs  so  early  that 
no  opportunity  has  been  given  for  providing  for  such  losses,  and 
it  is  presumable,  on  the  law  of  averages,  that  the  near  future 
will  escape  them;  so  that  this  is  a  cost  borne  now  for  the  future. 
In  case  a  deficit  is  shown,  it  is  well  to  call  it  Capital  Deficit,  to 
distinguish  it  from  any  accumulated  deficit  arising  from  normal 
operations.  It  can  be  wiped  out  by  later  credits  to  Provision 
for  Maritime  Losses  transferred  to  Capital  Deficit.  If  the  loss 
occurs  after  sufficient  provision  for  maritime  losses  has  been 
made,  an  entry  debiting  Provision  for  Maritime  Losses  and  cred- 
iting the  steamship  accotmt  or  an  allowance  accoimt  is  all  that 
is  necessary. 

Statement  of  Surplus.  We  have  now  seen  that  a  complete 
story  of  a  business  may  require  not  two  but  three  statements. 
The  operating  statement  (or  income  sheet)  shows  the  business  of 
the  period  as  it  is  chargeable  and  creditable  to  the  period,  but  it 
does  not  show  items  that,  though  they  occurred  in  the  period,  be- 
long properly  to  other  periods.  The  balance  sheet  shows  the 
effect  of  both  sets  of  items,  but  cannot  distinguish  between  them. 
So  a  third  statement  is  often  desirable  to  show  what  changes  have 
taken  place  in  surplus  during  the  last  period.  Additions  may 
have  been  made  to  surplus  from  extraordinary  kinds  of  gain,  such 
as  refunds  of  taxes  levied  in  earher  periods  under  erroneous  inter- 
pretations of  law,  and  collections  of  debt  written  off  in  previous 
periods  as  imcoUectible;  and  numerous  deductions  may  be  made, 


290  THE  FUNDAMENTALS  OF  ACCOUNTING 

as  for  an  excessive  amount  of  debt  of  earlier  periods  proved  un- 
collectible, and  discovery  of  insufficient  provision  for  depreciation 
in  earlier  periods.  If  such  facts  are  not  reported  to  owners,  they 
may  well  complain  that  they  are  not  kept  informed  of  all  they 
should  know. 

Capital  Gains.  Akin  to  capital  losses  discussed  above,  but  op- 
posite in  nature,  are  capital  gains.  Where  trusts  are  involved 
faulty  accoimting  for  them  sometimes  leads  to  great  injustice. 
Suppose  a  building  is  owned  by  an  estate  of  which  the  income  is  to 
be  received  by  one  beneficiary  and  the  principal  or  capital  is  to  be 
kept  intact  for  another  for  use  after  the  death  of  the  life-benefi- 
ciary; if  now,  because  of  changes  in  real-estate  conditions,  the 
building  is  sold  for  a  larger  sum  than  its  previous  value,  is  the  gain 
a  gain  of  capital  or  of  income?  Supposing  this  gain  has  come  not 
from  real-estate  operations  conducted  by  the  trustee  as  a  regular 
part  of  his  management  of  the  estate,  but  from  peculiar  circum- 
stances independent  of  normal  operations,  it  has  come  as  an  in- 
crease in  the  capital  of  the  estate,  not  as  income  of  any  particular 
year  or  of  any  series  of  years  (unless,  indeed,  the  property  was  se- 
cured in  the  first  instance  for  the  purpose  of  catching  the  growth 
in  real-estate  values,  in  which  case  a  new  set  of  accounting  con- 
siderations, involving  a  good  deal  of  mathematics,  becomes 
involved).  Such  gain  of  capital  should  be  credited  to  Capital 
Surplus,  so  that  it  shall  not  become  confused  with  accumulated 
general  surplus,  or  undivided  profits,  and  suffer  distribution  as 
regular  dividends,  misleading  the  stockholders  as  to  the  earn- 
ings of  their  property,  and  possibly  giving  to  a  life-beneficiary 
property  that  should  be  held  as  capital  to  earn  income  later  for 
both  life-beneficiary  and  remainder-beneficiary. 

Special  Gains.  Occasionally  gains  akin  to  capital  gains  just 
discussed  are  made,  and  yet  they  are  current  rather  than  capital 
gains.  If  a  business  finds  in  the  dull  season  that  it  has  surplus 
cash  which  it  will  need  in  the  active  season,  it  may  temporarily 
invest  that  cash  in  stocks  and  bonds  so  that  it  may  be  earning  an 
income.  If  in  addition  to  the  interest  and  dividends  earned  it 
finally  sells  those  stocks  and  bonds  at  a  profit,  or  makes  several 
changes  of  investment  that  yield  a  profit,  that  profit  is  profit  of 
the  period.    For  convenience,  in  order  not  to  confuse  the  stock 


WHERE  DO  PROFITS  BEGIN?  291 

and  bond  accounts  with  earning  accounts,  it  may  well  credit 
the  former,  when  securities  are  sold,  for  the  cost  as  originally 
debited,  and  enter  any  losses  or  gains  to  Stock  and  Bond 
Sales.  Then  the  stock  and  bond  accounts  would  be  pure  asset 
accounts. 

Income  Taxes.  Theoretically,  income  taxes  are  not  costs,  for 
they  constitute  a  sharing  of  profits  with  the  government,  and 
profits  do  not  begin  until  all  costs  have  been  met.  In  a  sense,  the 
term  *' income  tax"  is  a  contradiction  in  terms,  for  if  the  tax  is 
taken  out  of  so-called  income,  the  so-called  income  is  not  actual 
income;  and  so  no  tax  can  be  in  reality  an  income  tax.  The  so- 
called  income  tax,  properly  speaking,  is  a  tax  based  upon  what 
income  would  be  if  no  income  tax  were  payable.  To  the  payer, 
the  tax  is  a  cost,  for  his  actual  profits  do  not  begin  until  after 
his  tax  has  been  met.  For  convenience  in  showing  the  basis 
of  the  tax,  on  financial  statements  the  tax  is  commonly  not 
included  in  costs  but  is  subtracted  from  what  otherwise  would 
be  profits. 

Summary.  We  have  observed  that  costs  in  an  accounting  point 
of  view  are  disappearances  of  value  in  the  acquisition  of  other 
values;  that  they  may  constitute  mere  exchanges  of  value,  or  con- 
versions of  value;  that  they  may  be  chargeable  to  one  earning 
period  or  to  many;  that  just  what  are  the  disappearances  of  value 
for  any  particular  period  is  not  always  easy  to  determine;  that 
against  what  returns  or  yield  converted  costs  are  chargeable  is  not 
always  easy  to  determine;  that  gain  consists  of  return  less  cost 
and  it  may  belong  to  a  particular  earning  period  or  periods,  or  to 
no  particular  periods,  in  which  latter  case  it  is  a  gain  of  capital.  A 
more  detailed  study  of  disappearances  of  value  is  made  in  Chapter 
XVni  in  connection  with  depreciation. 

QUESTIONS  AND  PROBLEMS 

I.  During  the  construction  of  a  biulding  you  find  necessary  the  services 
of  a  night  watchman  to  protect  it  from  vandals  and  thieves  of 
building  materials,  and  insurance  against  fire.  Are  the  watchman's 
wages  a  cost  of  the  building  and  chargeable  to  Real  Estate,  or  are 
they  operating  ei^penses?  Is  the  same  thing  true  of  the  insurance 
premium? 


292  THE  FUNDAMENTALS  OF  ACCOUNTING 

2.  A  trial  balance  on  December  31,  1920,  was  as  follows; 

Capital  Stock  ^                         123,600 

Bonds  Issued  24,000 

Stock  of  Affiliated  Companies  50,000 

Accounts  Payable  22,000 

Accounts  Receivable  86,000 

Purchases  84,000 

Inventory,  1/ 1/  20  2  7,000 

Interest  500 

Taxes  1,500 

Insurance  600 

Wages  7i00o 

Sales  107,000 

Office  Expenses  8,000 

Advertising  18,000 

Loss  from  Bad  Debts  1,000 

Income  from  Investments  6,000 

Cash  6,400 

Surplus  7>4oo 

290,000  290,000 


The  inventory  of  merchandise  on  December  31  at  cost  is  $40,000; 
the  market  value  of  the  inventory  is  $37,000.  The  advertising  is  not 
now  continuing,  but  there  has  been  no  apparent  decline  in  sales  since 
it  was  discontinued.  Of  the  sales,  $7,000  are  for  goods  sent  on  approval, 
and  not  yet  accepted.  Of  the  wages,  $500  have  been  incurred  in  the 
sale  of  goods  returned.  Insurance  to  the  amount  of  $300  has  expired, 
and  interest  has  accrued  against  the  company  to  the  amount  of  $100. 
Of  the  cash,  $1,400,  which  was  received  on  sales  made  in  Canada,  is  in 
a  Canadian  bank,  and  is  worth  in  this  country,  because  of  extraordinary 
exchange  conditions,  only  $1,200.  During  the  year  $2,000  of  accoimts 
receivable  have  been  written  off,  of  which  $1,000  is  for  sales  made  in 
,1919. 

Show  an  operating  statement,  and  the  surplus  account,  for  the  year 
1920.    Show  also  the  final  balance  sheet. 

A  plant  which  at  the  beginning  of  a  fiscal  year  has  been  depreciated  to 
$400,000  produces  a  product  during  the  year  at  a  cost,  exclusive  of 
depreciation,  of  $200,000.  The  estimated  depreciation  for  the  year  is 
$40,000.  At  the  end  of  the  year,  however,  the  plant  is  sold  for  $380,000. 
Should  depreciation  of  $40,000  be  charged  as  a  cost  of  the  product? 
Of  $20,000?  Explain  why  you  answer  as  you  do,  and  state  the  cost  of 
the  product. 

Find  the  operating  costs  for  the  fiiscal  period  and  the  balance  sheet  at 
the  end  of  it  from  the  figures  given  below. 

Ledger  balances  before  closing  the  books  Dec.  31,  1920,  follow: 
Capital  Stock  $93,750,  Plant  $70,675,  Bills  Receivable  $38,400,  Ac- 
counts Receivable  $29,500,  Cash  $14,065,  Bills  Payable  $37,500,  Ac- 
counts Payable  $6,250,  Sales  $80,250,  Wages  &  Salaries  $24,592,  Raw 


WHERE  DO  PROFITS  BEGIN? 


293 


Material  $37,908,  Merchandise  Discounts  Taken  $2,500,  Merchan- 
dise Discounts  Given  $440,  Power  $3,125,  Insurance  $155,  Taxes 
$310,  Interest  Charges  $410,  Commission  Charges  $1,875,  Ofl&ce 
Supplies  $180,  Sundry  Expenses  $4,505,  Repairs  $685,  Depreciation 
$425,  Surplus  :>7,ooo. 

Additional  information  is  obtained  as  follows:  notes  receivable  not 
shown  on  the  books  amounting  to  $4,400,  discounted  in  191 9,  were  to- 
day protested,  and  will  be  taken  up  to-morrow;  $1,000  of  specified  ac- 
counts receivable  and  $5,000  of  unspecified  accounts  receivable  are 
deemed  bad;  insurance  expired  is  $100;  taxes  have  accrued  against  the 
company  $200;  interest  liability  is  $100;  commission  liability  is  $125; 
the  inventory  of  raw  materials  is  $17,000,  but  its  market  value 
is  $18,000,  and  the  inventory  of  supplies  is  $80;  not  recorded  on 
the  books  is  a  loss  just  occurred  —  a  severe  storm  has  done  $750 
damage  to  the  plant,  but  $600  of  the  amoimt  is  recoverable  from 
insurance. 

The  balance  sheet  of  the  Adhesive  Chemical  Co.  as  drawn  up  by  the 
treasurer  is  as  follows: 


Cash 

$237,000 

Accrued  Items 

$76,000 

Accounts  Receivable 

769,000 

Accounts  Payable 

139,000 

Merchandise 

474,000 

Notes  Payable 

64,000 

Raw  Material 

63,000 

Capital  Stock 

1,200,000 

Goods-in-Process 

318,000 

Surplus 

1,280,800 

Fixtures 

12,000 

Dividends 

12,000 

Land 

400,000 

Buildings 

447,000 

Goodwill 

51,800 
$2,771,800 

$2,771,800 

To-day  the  market  value  of  the  land  is  $460,000,  and  of  the  buildings 
is  $400,000.  The  merchandise  has  a  market  value  of  $460,000.  Of 
the  Goods-in-Process,  $18,000  are  defective  and  have  a  scrap  value 
of  $2,000.  The  Good  Will  represents  an  advertising  campaign  of  a 
few  years  ago.  The  fixtures  cost  $12,000  five  years  ago,  but  are 
now  worth  only  $9,000.  The  dividends  shown  were  declared  two 
years  ago  but  have  never  been  claimed  by  the  then  stockholders. 
Of  accounts  receivable,  the  general  uncollectibility  is  estimated  at 
$69,000. 

Is  the  balance  sheet  correct?  If  so,  defend  it.  If  not,  what  should 
be  done  to  correct  it?  Show  the  balance  sheet  as  you  think  it  should 
look. 

You  have  agreed  to  sell  your  entire  output  of  manufactured  goods  for 
two  years  to  an  associate  at  cost  plus  10%  of  the  cost.  What  should 
you  have  charged  for  the  goods  which  were  produced  in  the  first  year 
under  the  conditions  given  on  the  next  page  ?  The  goods  were  actually 
sold  for  $275,000. 


294  THE  FUNDAMENTALS  OF  ACCOUNTING 

Trial  Balance,  Dec.  31 


Capital  Stock 

Real  Estate 

$50,000 

Account  Receivable 

60,000 

Goods-in-Process,  beginning 

50,000 

Raw  Material 

50,000 

Plant 

75,000 

Cash 

15,000 

Surplus 

Wages  &  Salaries 

184,000 

Maintenance 

5,000 

Insurance 

2,200 

General  Expenses 

15,000 

Rent  of  Real  Estate  Let 

Fire  Loss 

5,000 

Sales 

$190,000 


44,200 


2,000 


275,000 


$511,200      $511,200 

The  real  estate  includes  property  occupied,  $30,000,  and  property 
rented,  $20,000.  There  is  no  need  for  an  allowance  for  bad  debts, 
for  your  one  customer  is  sure  to  pay  for  the  goods.  The  inventory  of 
goods-in-process  at  the  end  is  $40,000;  of  raw  material,  $18,000.  The 
plant  has  depreciated  $2,000. 

Wages  &  Salaries  includes  $2,000  of  unearned  salaries,  paid  during 
a  shut-down  due  to  a  fuel  shortage,  $3,000  paid  for  the  installation  of 
a  sprinkler  system,  and  $40,000  paid  for  administrative  salaries.  The 
insurance  charge  includes  insurance  on  plant  $1,400,  on  merchandise 
$600,  and  on  real  estate  rented  $200.  Of  the  General  Expenses  one- 
third  was  incurred  for  manufacturing,  and  two-thirds  for  admim'stra- 
tion.  The  fire  loss  resulted  from  a  fire  in  the  rented  property.  Ad- 
ministrative costs  of  $5,000  have  been  incurred  but  have  not  yet  been 
paid  for. 

Construct  an  operating  statement  to  show  whether  the  selling 
price  was  in  accord  with  the  cost-plus  contract;  and  show  the  surplus 
accoimt  for  the  year. 


CHAPTER  XVm 

DEPRECIATION  AND  MAINTENANCE 

Summary  of  Previous  Discussion.  We  have  already  observed  in 
Chapter  VIII  that  depreciation  as  a  cost  consists  of  shrinkage  in 
value  with  regard  to  the  use  made  of  property,  and  has  no  con- 
cern with  shrinkage  which  would  be  suffered  if  the  property  were 
shifted  to  another  use,  as  sale  instead  of  production;  that  one  kind 
of  depreciation  is  obsolescence,  which  though  due  to  changes  out- 
side the  property  itself  affects  the  value  of  the  property  through 
a  supplanting  of  it  or  through  the  demand  for  its  product;  that 
maintenance  consists  of  repairs  or  replacements  which,  as  far  as 
they  go,  offset  depreciation;  that  so  far  as  cost  is  concerned  there 
is  no  difference  between  depreciation  and  maintenance  —  the 
first  representing  a  gradual  and  continuous  outlay  of  fixed  prop- 
erty, and  the  second  an  occasional  outlay  of  cash  (or  incurring  of 
debt)  in  the  avoidance  or  the  overcoming  of  the  first,  so  that  both 
are  outlays  and  the  only  difference  Kes  in  the  form  which  the  out- 
lay takes.  We  also  saw  in  Chapter  IV  that  depreciation  when 
the  result  of  business  operations  and  not  of  mischance  consists  in 
converting  values  formerly  in  fijced  assets  into  quickly  moving 
assets,  as  value  in  machinery  gradually  converted  by  productive 
processes  into  value  in  manufactured  goods.  This  conversion, 
moreover,  must  in  the  long  run  apply  to  obsolescence  as  well  as  to 
deterioration  by  wear  and  tear,  for  prices  of  goods  must  in  the 
long  run  yield  a  reasonable  return  on  costs,  and  among  the  costs  is 
obsolescence  of  property  due  to  the  constantly  shifting  demands 
of  the  public.  In  any  particular  case,  if  the  obsolescence  is  not 
recovered  in  the  manufactured  product  it  is  a  loss  of  the  owners  of 
the  business  —  like  all  other  debits,  when  it  does  not  represent  an 
asset  acquired  it  represents  an  ownership-claim  reduced. 

Depreciation  without  Maintenance.  Sometimes  property  has  a 
usefulness  so  short,  either  naturally  or  because  of  changes  outside 
itself  that  have  reduced  its  natural  usefulness,  that  the  most  eco- 
nomical treatment  of  it  is  to  wear  it  out  as  quickly  as  possible. 
Replacement  is  sometimes  cheaper  than  care,  particularly  if  obso- 


296  THE  FUNDAMENTALS  OF  ACCOUNTING 

lescence  is  going  on  rapidly;  for  obsolescence  goes  on  day  and 
night,  Sundays  and  holidays,  whether  the  machine  is  used  much 
or  Httle,  and  so  sometimes  one  must  get  even  with  it  by  forcing 
the  machine  to  do  all  it  can  before  obsolescence  renders  it  worth- 
less. The  extreme  case  of  this  would  be  one  in  which  the  only 
cost  for  wear  and  tear  would  be  depreciation  without  mainte- 
nance. Supposing  such  a  machine  to  endure  three  years  without 
repairs  or  replacement  of  parts  after  the  policy  is  decided  upon, 
the  operating  statement  will  show  each  year  a  charge  for  depre- 
ciation (without  any  for  maintenance),  and  a  reduction  of  the 
machinery  account,  or  an  increase  in  the  allowance  account,  for  a 
similar  amount.  Then  when  replacement  of  the  exhausted  prop- 
erty takes  place,  a  charge  will  be  made  to  the  machinery  account 
(or  to  the  allowance  account  to  reduce  the  size  of  the  recorded 
"hole  in  the  asset"),  restoring  the  original  situation.  Main- 
tenance does  not  appear  on  the  books  at  all.  This  is  of  course 
rather  theoretical  than  real,  for  it  is  hardly  conceivable  that  prop- 
erty should  run  three  years  without  some  repairs,  even  though  it 
was  the  wise  policy  to  reduce  repairs  to  a  minimum  and  to  ex- 
haust the  property  as  rapidly  as  is  consistent  with  economy;  but 
this  case  illustrates  what  we  mean  by  a  policy  of  depreciation  as 
contrasted  with  a  policy  of  maintenance. 

Maintenance  without  Depreciation.  Much  more  common  is 
the  reverse  case.  It  is  true  that  no  piece  of  property  can  be  main- 
tained in  pristine  value  by  repairs,  or  by  replacement  of  parts,  for 
obsolescence  goes  on  and  cannot  be  offset;  but  property  in  large 
aggregations  can  be  maintained,  for  while  some  pieces  are  growing 
less  valuable  by  obsolescence,  other  pieces  may  be  replaced  by 
substitutes  that  have  greater  value  than  what  they  replaced.  A 
simple  illustration  of  this  is  railroad  equipment.  A  road  may 
have  $10,000,000  worth  of  locomotives  and  cars,  some  nearly  new, 
some  of  average  age,  and  some  about  ready  for  the  scrap  heap. 
Let  us  suppose  that  during  the  year  it  sends  to  the  scrap  heap 
equipment  having  a  value  on  the  books  of  $100,000,  and  that, 
after  allowing  for  repairs  made,  the  depreciation  on  the  rest  of  the 
equipment  amounts  to  $600,000.  Supposing  (for  the  sake  of 
illustration,  though  practically  this  is  not  quite  possible)  that  the 
abandoned  equipment  has  no  value,  the  total  depreciation  is  of 


DEPRECIATION  AND  MAINTENANCE  297 

course  $700,000 ;  but  if  during  the  period  new  equipment  is  bought 
for  $700,000  to  replace  that  depreciated,  no  depreciation  of  the 
property  as  a  whole  has  occurred;  for  though  some  of  that  which 
was  previously  new  has  grown  older,  and  some  which  was  of  aver- 
age age  is  now  approaching  abandonment,  and  still  other  is  ready 
for  abandonment,  so  much  has  been  added  in  value  through  the 
substitution  of  new  equipment  for  that  which  was  a  year  ago 
about  ready  for  abandonment,  that  the  net  condition  of  equip- 
ment as  a  whole  is  exactly  what  it  was  a  year  ago,  and  no  deprecia- 
tion, taking  the  year  as  a  whole,  has  occurred  —  though  during 
parts  of  the  year  depreciation  has  been  incurred  and  in  other  parts 
has  been  overcome.  The  balance  sheet  will  show  no  change,  and 
the  operating  statement  for  the  whole  period  will  show  $700,000 
for  maintenance. 

Maintenance  with  Depreciation.  Common  operating  condi- 
tions involve  both  maintenance  and  depreciation,  not  only  from 
choice  but  from  necessity.  In  the  first  place,  some  kinds  of  prop- 
erty cannot  be  economically  maintained,  for  the  simple  reason  that 
consisting  of  wholes  and  not  of  parts  and  lasting  many  years  there 
is  no  way  to  replace  them  except  at  long  intervals.  Though  the- 
oretically a  machine  can  be  kept  in  good  condition  forever  by  the 
replacement  of  one  part  after  another  as  the  parts  wear  out,  in 
fact  this  is  virtually  impossible,  for  obsolescence  sets  in.  A  build- 
ing, on  the  other  hand,  being  a  structural  unit,  must  be  more  or 
less  destructively  torn  to  pieces  whenever  replacement  of  parts 
occurs.  The  only  way  in  which  a  building  can  be  maintained 
without  depreciation  is  by  constant  additions  and  improvements 
in  one  direction  that  offset  inevitable  loss  of  usable  value  (or  share 
in  final  disappearance  of  value)  in  another,  so  that,  so  to  speak, 
like  the  nautilus  one  moves  out  of  the  old  building  into  the  new 
bit  by  bit  until  the  old  is  abandoned.  This  is  of  course  extremely 
rare.  The  only  other  case  in  which  real  estate  can  be  maintained 
is  that  in  which  many  pieces  of  real  estate  are  held  and  deprecia- 
tion on  some  is  offset  by  improvements  on  others;  but  since  usu- 
ally, and  desirably,  every  piece  of  real  estate  is  given  a  separate 
ledger  account  (as  separate  pieces  of  equipment  and  machinery 
are  not),  this  is  not  in  practice  a  situation  that  avoids  deprecia- 
tion.   So  normally  depreciation  and  maintenance  are  coincident. 


298  THE  FUNDAMENTALS  OF  ACCOUNTING 

Depreciation  of  New  Property.  Another  kind  of  case  com- 
monly involves  unavoidable  depreciation  even  though  on  its  face 
it  seems  a  case  where  maintenance  will  serve  all  needs.  If  a  busi- 
ness has  a  new  plant  throughout,  even  though  the  equipment  con- 
sists as  a  whole  of  many  parts  so  that  it  seems  possible  to  offset 
depreciation  of  some  parts  by  improvement  of  others,  so  long  as 
the  property  is  fairly  new  no  appreciable  number  of  parts  need 
replacement  and  no  opportunity  is  offered  to  offset  the  deprecia- 
tion of  all.  All  are  depreciating  together.  Never  again,  pre- 
sumably, will  the  plant  be  all  new  —  at  least  such  a  circumstance 
is  unlikely  to  happen  again  in  a  great  many  years  in  the  same 
business  —  for  not  all  parts  will  have  the  same  life  or  depreciate 
at  the  same  rate.  So  it  virtually  is  impossible  by  maintenance 
to  restore  the  plant,  for  the  original  condition  of  universal  new- 
ness is  impossible  of  attainment.  The  case  becomes  like  that 
of  real  estate  —  though  not  from  the  nature  of  the  property,  but 
from  the  circumstances  attending  its  purchase.  Only  in  case  ad- 
ditions were  made  to  the  plant  annually,  offsetting  the  gradual 
depreciation,  can  the  value  of  the  whole  be  maintained.  To  put 
this  in  another  way,  the  normal  condition  of  any  plant  is  one  of 
half-newness  —  some  property  new,  some  of  average  age,  some 
old,  and  some  in  all  the  intermediate  stages;  after  equilibrium  has 
once  been  established  —  that  is,  a  normal  working  basis  —  the 
task  of  maintenance  is  to  keep  the  property  as  ejQ&cient  as  pos- 
sible at  the  greatest  age  consistent  with  economy,  and  of  de- 
preciation is  to  represent  the  cost  or  outlay  that  maintenance  has 
not  taken  care  of. 

The  Debits  and  Credits.  Remembering  that  books  are  not 
kept  written  up  to  the  time,  we  must  now  see  that  what  will  be 
debited  at  the  time  of  adjustment  depends  largely  on  the  time  of 
making  an  entry,  and  the  credit  depends  upon  the  debit.  If  at 
the  time  of  making  an  entry  to  bring  the  books  to  the  time  we  find 
that  we  have  not  maintained  our  property  for  the  period,  we  debit 
Depreciation  and  credit  the  property  or  Allowance  for  Deprecia- 
tion; if  we  find  that  we  have  maintained  our  property  we  make  no 
entry,  for  Maintenance  has  already  been  debited  and  Cash  (or 
some  other  real  account)  has  been  credited;  if,  on  the  other  hand, 
the  property  has  already  been  written  down  on  the  books  for  de- 


DEPRECIATION  AND  MAINTENANCE  299 

preciation,  either  in  the  same  period  or  earlier,  we  must  not  when 
we  replace  it  debit  Maintenance  but  must  debit  the  property  ac- 
count (or  Allowance  for  Depreciation)  —  else  the  outlay  will  be 
charged  to  costs  twice,  once  when  the  property  was  worn  out  and 
again  when  it  was  replaced;  but  both  Depreciation  and  Mainte- 
nance are  nominal  accounts  and  represent  costs.  The  entry  for 
closing  the  books,  then,  depends  upon  what  has  happened  since 
the  books  were  last  adjusted  to  the  facts.  This  may  be  smn- 
marized  as  follows:  we  debit  Depreciation  for  the  outlay  (ex- 
haustion, part  or  whole)  of  the  property  itself  since  the  last  ad- 
justment of  the  books;  we  debit  Maintenance  for  the  outlay 
which  overcomes  depreciation  since  the  last  adjustment  of  the 
books  if  the  depreciation  has  not  already  been  debited  to  Depre- 
dation; we  debit  the  property  account  (or  Allowance  for  Depre- 
ciation) for  outlay  which  overcomes  depreciation  that  has  already 
been  entered  on  the  books. 

Debits  and  Credits  Illustrated.  Suppose  we  own  a  piece  of  real 
estate  with  a  value  on  the  books  of  $30,000  on  January  i.  On 
March  31  we  wish  to  prepare  local  tax  returns,  and  in  preparation 
for  this  we  decide  to  enter  upon  our  books  depreciation  up  to  this 
time.  As  we  have  made  no  repairs  since  January  i ,  let  us  suppose 
that  we  debit  Depreciation  and  credit  Real  Estate  $150  ($50  a 
month),  giving  us  a  book  value  for  real  estate  of  $29,850.  On 
April  30,  we  spend  $200  for  repairs.  To  what  shall  we  charge  it? 
If  we  assume  $50  a  month  equivalent  to  complete  maintenance,  as 
we  did  for  the  first  three  months  of  the  year,  it  is  obvious  that  we 
have  now  for  the  four  months  maintained  the  property  —  though 
some  portions  of  the  building  are  in  poorer  condition  than  four 
months  ago  other  portions  are  better  and  the  general  condition  is 
the  same.  The  building  is  in  value  back  where  it  was  on  January 
I ;  but  on  the  books  it  is  now  at  $150  less.  We  may  charge  Real 
Estate  for  that  $1 50.  The  other  $50,  however,  we  may  not  charge 
to  Real  Estate,  or  we  shall  have  the  property  overvalued.  It  has 
been  spent  in  keeping  the  property  unimpaired  during  April  and 
is  an  April  operating  cost,  not  chargeable  to  the  asset  account, 
because  already  converted  by  use.  So  it  is  charged  to  Mainte- 
nance. Here  are  our  three  typical  debits  for  wear  and  tear:  to 
Depreciation,  for  exhaustion  of  value;  to  the  property  account, 


3CX)  j  ,THE  FUNDAMENTALS  OF  ACCOUNTING 

for  replacement  of  value  that  has  already  been  written  down;  to 
Maintenance,  for  replacement  of  value  before  it  has  been  written 
down.  In  case  the  property  has  not  been  written  down  directly 
but  has  been  written  down  through  a  contra,  or  allowance,  ac- 
count, the  substitution  of  the  allowance  account  for  both  the  debit 
and  the  credit  to  the  property  account  completes  the  illustration 
of  entries. 

Objection  to  Frequent  Record  of  Depreciation.  In  the  example 
given  in  the  preceding  paragraph,  it  will  have  been  noted  that  in 
closing  the  books  for  these  four  months  $150  will  be  transferred 
to  Operating  Expenses  or  other  clearing  account  from  Deprecia- 
tion, and  $50  will  be  transferred  from  Maintenance;  and  the 
charges  to  be  carried  to  the  operating  statement  consist  of  $150 
for  depreciation  and  $50  for  maintenance.  Yet  this  is  false.  It 
gives  a  distinct  impression  of  neglect  of  the  property,  and  though 
it  does  not  overstate  costs  it  does  misrepresent  the  kinds  of  cost 
incurred.  That  is  the  objection  to  entry  of  depreciation  on  books 
of  account  before  the  end  of  the  period  to  be  reported,  for  before 
the  end  of  the  period  the  depreciation  may  be  overcome  by  main- 
tenance, and,  if  the  property  or  allowance  has  already  been  cred- 
ited for  the  depreciation,  the  entry  for  restoration  must  debit  the 
property  or  allowance  account  and  leave  the  false  impression  on 
Depreciation  uncorrected.  To  report  things  truly,  then,  either 
depreciation  should  not  be  entered  imtil  the  end  of  the  period, 
when  it  may  be  known,  or  a  device  for  correcting  the  misleading 
statistical  figures  should  be  adopted.  In  this  case,  the  obvious 
thing  is  at  the  time  of  the  $150  of  restoration  accomplished  in 
April  to  make  an  additional  entry  to  overcome  the  depreciation 
of  the  first  three  months,  debiting  Maintenance  and  crediting 
Depreciation.  As  this  entry  involves  only  statistical  accounts, 
an  exchange  of  classification  of  an  item  from  one  statistical  ac- 
count to  another,  and  as  the  ultimate^  disposition  of  the  charge 
is  the  same  in  whichever  place  its  stands  (Operating  Expenses,  or 
Loss  and  Gain,  or  what  not),  it  is  not  only  harmless  but  desirable 
if  statistics  are  to  be  useful.  It  is  better  to  avoid  the  misleading 
first  entry  and  thereby  avoid  the  necessity  for  the  second  or  cor- 
rection entry.  This  may  be  accomplished  by  a  temporary  or 
interim  account  for  depreciation. 


DEPRECIATION  AND  MAINTENANCE  3OI 

Repairs,  Replacements,  and  Betterments.  Repairs  consist  of 
minor  changes  restoring  the  property  to  serviceabiHty  or  prevent- 
ing it  from  becoming  unserviceable  when  the  changes  consist  in 
the  alteration  of  adjustments,  change  in  the  shape  of  parts,  sub- 
stitution of  small  parts  not  integral  but  subordinate  units  (sub- 
ordinate parts,  bolts,  nuts,  rods,  etc.,  but  not  integral  parts  like 
feeds,  wheels,  frames,  etc.).  Replacements,  on  the  other  hand, 
consist  of  the  substitution  of  complete  units,  whether  integral 
parts  of  single  machines  or  whole  machines,  for  old  units  aban- 
doned. They  equally  constitute  costs,  and  in  one  point  of  view, 
therefore,  need  no  differentiation.  In  another  respect,  however, 
they  are  fundamentally  unlike:  repairs  can  never  do  more  than 
offset  depreciation,  for  they  can  never  make  the  property  better 
than  it  was  before  the  repair  became  necessary;  but  replacement 
may  substitute  a  better  part  or  even  a  better  whole  machine  and 
therefore  improve  the  property  to  better  than  its  original  state. 
Replacements,  then,  may  increase  assets  if  they  exceed  deprecia- 
tion. In  that  case,  the  excess  of  replacement  over  depreciation 
not  covered  by  repairs  is  often  called  "betterment."  If  our  esti- 
mated wear  and  tear  annually  for  a  plant  is  $12,000,  if  our  repairs 
are  $3,000,  and  if  our  replacements  are  $2,500,  depreciation  is  ob- 
viously $6,500;  but  if  our  repairs  are  $3,000  and  our  replacements 
are  $10,000,  betterment  is  obviously  $1,000  and  should  be  charged 
to  the  property  account,  or  be  carried  in  a  special  account  for 
betterments  of  property.  Some  accountants  dislike  to  add  to  the 
property  account  directly  unless  an  actual  increase  in  the  number 
of  imits  of  plant  has  occurred  —  i.e.,  unless  there  are  more  things 
to  be  counted  —  and  hence  carry  to  Betterments  all  increases  in 
value  of  property  where  no  increase  in  the  number  of  pieces  of 
property  has  occurred.  Sometimes  a  distinction  is  made  between 
depreciation  of  property  continued  in  use  and  abandonment  of 
property.  When  that  is  done,  Depreciation  is  used  for  the  first, 
and  Retirement  for  the  second;  both  of  course  are  costs;  in  most 
businesses  this  is  an  unnecessary  refinement. 

Methods  of  Estimating  Depreciation.  We  have  already  ob- 
served that  the  distribution  of  depreciation  between  periods  is 
important.  It  is  also  difficult.  The  difficulty  arises  from  two 
causes:  the  total  depreciation  itself  is  impossible  to  learn  imtil  the 


302  THE  FUNDAMENTALS  OF  ACCOUNTING 

end  of  the  use  of  the  property;  and  the  elements  entering  into  a 
basis  for  fair  distribution  between  periods  are  so  numerous  and  so 
conflicting  that  choice  between  them  is  bound  usually  to  appear 
to  violate  fairness  somewhere.  No  attempt  can  be  made  here  to 
discuss  all  the  principles  of  distribution,  to  take  up  all  the  methods 
found  in  practice,  or  even  to  show  the  common  rates  of  deprecia- 
tion applied  to  specific  kinds  of  property.  Such  things  belong  in  a 
book  on  depreciation.  All  we  can  do  here  is  to  give  a  few  illustra- 
tions of  common  methods  and  principles. 

Simple  Bases  of  Depreciation.  The  most  obvious  basis  for 
depreciation  is  time,  for  property  depreciates  through  mere  lapse 
of  time,  especially  because  of  obsolescence  and  of  weathering 
(both  outside  weathering  and  inside  climatic  conditions).  It  also 
depreciates  largely  from  use,  wear  and  tear,  and  hence  product  is 
an  obvious  basis  for  depreciation.  Again,  since  the  value  of  prop- 
erty is  dependent  on  what  it  will  produce,  and  after  a  machine  has 
reached  a  certain  limit  of  maximum  production  it  not  only  pro- 
duces less,  and  possibly  poorer  goods,  but  costs  more  for  repairs 
and  operation,  the  depreciation  may  take  into  account  its  value 
in  such  respects.  These  and  other  considerations  are  pertinent. 
The  main  difficulty  with  them  is  that  they  conflict,  and  to  give 
them  due  weight  would  mean  elaborate  mathematical  calcula- 
tions to  find  the  amount  of  emphasis  each  should  have. 

The  Straight-Line  Method.  The  simplest  basis  is  the  time 
basis,  giving  what  is  commonly  called  the  "straight-line  method," 
because  on  a  graphic  chart  the  line  of  the  value  of  the  property  is 
straight.  If,  for  example,  a  machine  cost  $i,ooo,  is  expected  to 
last  eight  years  and  then  to  have  a  scrap  value  of  $ioo,  the  annual 
depreciation  is  $112.50  [(1,000—100)  -^  8].^  It  neglects  at  least 
three  rather  important  facts:  (i)  one  does  not  need  to  save  $1 12.50 
out  of  product  now  and  each  year  for  eight  years  in  order  to  ac- 
cumulate $900  in  eight  years,  for  money  will  earn  interest,  and 
hence  less  than  $112.50  a  year  is  sufficient;  (2)  the  machine  will 
require  more  repairs  in  later  periods,  and  hence,  to  distribute  its 
cost  evenly  over  all  periods,  the  periods  in  which  repair  charges 
are  low  should  bear  more  for  depreciation;  (3)  the  product  of  the 
machine  may  not  run  evenly  over  the  years,  and  probably  will 
*  This  is  shown  graphically  on  page  305. 


DEPRECIATION  AND  MAINTENANCE  303 

not,  for  seasons  differ,  and  if  one-eighth  of  total  depreciation  is  to 
be  charged  to  product  each  year  irrespective  of  productiveness 
the  cost  per  unit  of  product  will  be  much  higher  when  production 
is  low  than  when  it  is  high.  In  spite  of  these  defects  this  is  the 
•commonest  method.  Its  simpUcity  is  deemed  to  offset  its  theo- 
retical weaknesses.  This  method  obviously  encourages  the  use  of 
the  contra  account  for  depreciation,  for  when  the  same  percentage 
of  original  cost  is  used  for  depreciation  year  after  year  it  is  con- 
venient to  have  original  cost  preserved  on  the  books  without  other 
change  than  additions  and  sales  (which  affect  the  amount  to 
which  the  percentage  is  to  be  applied). 

The  Sinking-Fund  Method.  In  general  principle  not  unlike  the 
straight-line  method  is  the  smking-fund  method;  but  it  allows  for 
the  fact  that  one  does  not  need  $112.50  a  year  for  eight  years  in 
order  to  accumulate  $900  in  eight  years,  for  interest  on  install- 
ments of  the  early  years  will  make  them  up  to  $112.50  each. 
So  the  installments  in  early  years  are  smaller,  and  the  calcula- 
tions are  those  of  sinking  funds,  which  are  discussed  in  Appen- 
dkC. 

The  Reducing-Balance  Method.  A  method  which  takes  cog- 
nizance of  the  fact  that  maintenance  wiU  cost  more  in  later  years, 
and  hence  depreciation  should  be  charged  more  in  early  years  in 
order  to  equalize  wear-and-tear  charges  over  the  hfe  of  the  ma- 
chine, applies  a  fixed  percentage  to  the  last  book  value,  and  hence 
gets  a  smaller  amount  for  depreciation  each  year;  for  a  constant 
percentage  on  a  diminishing  value  gives  a  diminishing  deprecia- 
tion. The  determination  of  the  percentage  requires  a  mathe- 
matical formula  (or  the  empirical  try-and- try-again  plan) .  If  our 
machine  has  a  cost  of  $1,000,  an  estimated  life  of  eight  years,  and 
an  estimated  scrap  value  of  $100,  the  rate  of  depreciation  for  any 
year  will  be  approximately  25%  on  the  value  of  the  preceding 
year,  giving  us  the  following  table  (cents  omitted) :  ^ 

*  The  formula  for  this  is  as  follows:  let  P  =  the  cost;  S  =  the  scrap  value; 
X  =  the  desired  rate;  p  =  the  number  of  periods  required  for  depredation;  then 

«  =  I  —  'V-p'     Applied  to  the  case  in  hand,  we  have  a;  «  i  —  -v/^^.     The 

100 
logarithm  of  ^^  is  i.     One  eighth  of  that  is  —.125  or  1.875.    The  natural 

number  corresponding  is  .74989.    i  —  .74989  *  .25011,  or  25.011%. 


304  THE  FUNDAMENTALS  OF  ACCOUNTING 


Book  value  * 

Depreciation 

Cost 

lOOO 

For 

year  i                    250 

End  year  i 

750 

2                   188 

2 

562 

3                    141 

3 

421 

4                     los 

4 

316 

5                       79 

5 

237 

6                      59 

6 

178 

7                      45 

7 

133 

8                      33 

8 

100 

It  is  clear  that  under  this  method  it  would  be  a  convenience  to 
have  depreciation  entered  directly  on  the  property  account,  so 
that  the  percentage  could  be  applied  directly  to  the  balance  of 
that  account  each  year.  This  method,  it  will  be  observed,  takes 
much  larger  shares  in  early  years  than  in  late,  for  its  purpose  is  to 
absorb  a  good  deal  of  depreciation  in  those  years.  A  reason  for 
doing  this,  in  addition  to  that  already  mentioned,  is  that  since 
depreciation  can  be  taken  only  by  guess  at  best,  and  poor  judg- 
ment may  lead  to  false  hopes,  it  is  wise  to  take  it  liberally  in  early 
years,  so  that  if  obsolescence  overtakes  the  machine  unexpectedly 
the  loss  will  not  be  suffered  too  heavily  all  at  once. 

The  Reducing-Fraction  Method.  The  mathematical  difficulty 
of  the  reducing-balance  method  is  one  drawback  to  its  use.  A 
convenient  substitute  Kes  in  arbitrary  fractions  that  produce  ap- 
proximately the  same  results.  What  we  desire  is  a  series  of  frac- 
tions that  will  progress  according  to  a  definite  plan  and  will 
amount  to  unity,  and  we  wish  one  fraction  for  every  year  of  the 
life  of  the  machine.  If  we  decide  to  use  fractions  of  which  the 
denominator  shall  be  common  to  all  and  the  numerator  shall  be 
decreased  by  one  each  year,  we  find  solution  of  our  problem  easy. 
If  for  the  last  year  the  fraction,  is  i/o:,  for  the  preceding  year  it 
will  be  2/Xy  for  the  next  preceding  3/it;,  etc.  Since  all  our  frac- 
tions together  must  equal  unity,  so  as  to  depreciate  the  property 
fully,  our  denominator  must  be  equal  to  the  sum  of  the  mmiera- 
tors,  and  the  highest  numerator  will  equal  the  nimaber  represent- 
ing the  life  of  the  machine.  So  to  find  our  denominator  we  add  to- 
gether the  numbers  representing  the  years  of  life;  as  14-2-1-3 
H-4-fS-|-6-h7  +  8«36.  Then  the  depreciation  for  the  first  year 
*  This  is  shown  by  a  graphic  chart  on  page  305. 


DEPRECIATION  AND  MAINTENANCE 


30s 


will  be  8/36,  for  the  second  7/36,  and  continuing  so  as  to  give  the 
series:  8/36,  7/36,  6/36,  5/36,  4/36,  3/36,  2/36,  1/36,  or  a  total 
of  36/36.  This  applied  not  to  the  decreasing  value  of  the  prop- 
erty but  to  its  original  value  gives  depreciation  and  values  for  our 
case  above  as  follows : 


Book  value 

Depreciation 

Cost 

1000 

For 

yeari                    200 

End  year  i 

800 

2                    175 

2 

62s 

3                    150 

3 

475 

4                    125 

4 

3SO 

5                    100 

5 

250 

6                     75 

6 

175 

7                     50 

7 

125 

8                     25 

8 

100 

This  is  most  conveniently  handled  when  depreciation  is  carried 
to  Allowance  for  Depredation,  for  the  fractions  are  applied 
always  to  original  cost.^ 


1000 


II.    m.   IV.    v.    VI.  VII.  vin. 


Depreciation     Charted. 

The  most  convenient  way 
to  compare  the  straight- 
line  and  the  reducing- 
balance  method  of  depre- 
ciation is  to  present  the 
book  values  under  the  two 
methods  in  the  form  of 
a  graphic  chart.  In  the 
chart  shown ,  the  horizontal 
lines  are  placed  at  inter- 
vals to  represent  himdreds  200 
of  dollars  of  value  remain- 
ing in  the  property,  and  ^^ 
the  vertical  lines  to  repre-     0 

*  If  it  is  desired  to  use  this  ty^  of  method  but  not  to  get  so  great  a  difference 
in  depredation  between  early  and  late  years,  the  denominator  in  the  last  year  may 
be  greater  than  i,  say  5:  then  the  series  would  run  as  follows:  12/68,  11/68, 
10/68,  9/68,  8/68,  7/68,  6/68,  s/68.  On  the  graphic  chart  shown  above  this 
would  give  a  flatter  curve  than  either  the  fractions  given  above  or  the  percentages 
of  the  redudng-balance  method,  for  it  would  give  a  50%  depredation  at  a  little 
later  than  the  end  of  the  third  year,  whereas  both  of  the  others  produce  50%  well 
before  the  end  of  the  third  year. 


900 


800 


700 


600 


600 


400 


800 


v 

\ 

\ 

\ 

\ 

\ 

\ 

\, 

\ 

V 

\ 

\ 

\ 

\ 

s. 

\ 

\ 

s 

\ 

s. 

\ 

V 

\ 

3C6  THE  FUNDAMENTALS  OF  ACCOUNTING 

sent  the  ends  of  years  of  the  life  of  the  machine.  The  straight 
oblique  line  shows  the  valuation  of  the  machine  imder  the 
straight-line  method,  beginning  at  $i,ooo,  passing  the  end  of 
year  I  at  the  level  of  $887.50,  the  end  of  year  II  at  the  level  of 
$775,  etc.,  and  ending  with  a  scrap  value  of  $100.  The  curved  line 
shows  the  same  sort  of  thing  for  the  reducing-balance  method,  and 
gives  a  very  heavy  drop  in  valuation  in  early  years  and  a  slow 
drop  in  late  years  —  very  nearly  one-half  being  written  off  in  the 
first  two  years. 

Application  of  Blanket  Rates.  It  is  obvious  that  if  depreciation 
must  be  taken  into  account  for  large  groups  of  assets  at  once, 
rather  than  for  single  items  of  property,  it  is  desirable  to  classify 
items  of  property  in  such  a  way  that  no  two  items  subject  to  dif- 
ferent rates  of  depreciation  shall  be  carried  to  the  same  property 
account.  If  this  precaution  is  taken,  it  may  be  possible  to  apply 
a  rate  of  depreciation  to  a  whole  property  account  at  once  and 
thus  reduce  the  labor  of  calculation  to  a  mim'mum.  This  is  actu- 
ally possible,  however,  only  if  one  of  the  two  following  supposi- 
tions is  true:  all  property  in  the  account  is  of  the  same  age,  or  the 
straight-line  method  of  depreciation  is  used;  for  otherwise  though 
the  rates  might  be  the  same  for  corresponding  years  in  the  life  of 
the  machines,  they  would  not  be  appKcable  at  actually  the  same 
times.  This  is  an  additional  reason  for  the  popularity  of  the 
straight-line  method:  the  same  rate  is  applied  to  all  property  of 
the  same  type  (i.e.,  the  same  estimated  life),  and  hence  it  is  ap- 
plied to  all  property  in  the  account  for  one  class,  irrespective  of 
its  age. 

Appraisal  Method.  Sometimes  no  predetermined  plan  or  rate 
of  depreciation  is  adopted,  but  each  year  an  examination  is  made 
of  the  property  and  the  shrinkage  is  determined  by  observation. 
This  should  be  independent  of  changes  in  market  price  of  corre-  . 
sponding  new  property,  for  we  are  concerned  here  not  with  re- 
placement but  with  depreciation  of  old,  as  we  saw  on  page  279. 
When  valuation  can  be  found,  and  distribution  of  depreciation 
over  periods  can  be  made  more  accurately  this  way  than  by  a  pre- 
determined rate,  this  is  a  better  method. 

Providing  for  Replacement.  So  far  we  have  considered  only 
the  cost  aspect  of  depreciation.    The  business  manager  is  usually 


DEPRECIATION  AND  MAINTENANCE  307 

concerned  also  with  the  practical  provision  for  replacement. 
Shall  he  accumulate  a  fund  ready  for  the  day  when  replacement 
of  worn-out  property  becomes  necessary?  If  so,  where  is  the 
money  coming  from  to  establish  and  continue  the  fund?  If  he 
does  not  establish  such  a  fimd,  from  what  source  will  come  the 
money  necessary  to  replace  the  property  worn  out?  Many  a 
manager  has  been  puzzled  by  these  questions.  The  first  thing  is 
to  see  just  what  has  been  accomplished  by  making  entries  for  de- 
preciation. In  the  first  place,  we  have  not  secured  assets  by  such 
entries,  for  bookkeeping  never  produces  assets.  All  that  our 
bookkeeping  did  was  to  point  out  that  wear  and  tear  of  property 
was  a  cost  of  operations,  that  profits  could  not  begin  until  that 
wear  and  tear  had  been  returned  in  the  product,  and  that  a  part  of 
the  product  (in  whatever  form  it  happened  to  be  —  whether 
goods-in-process,  finished  goods,  accounts  receivable,  or  cash) 
was  nothing  but  former  real  estate,  machinery,  or  what  not,  con- 
verted into  more  nearly  liquid  form.  Our  entries  showed  us  that 
unless  the  business  has  suffered  a  loss  the  property  for  replace- 
ment is  already  available  for  replacement,  though  it  may  not 
chance  to  be  in  form  sufficiently  Uquid  at  this  moment  (for  one 
cannot  usually  buy  machinery  directly  with  merchandise  or  ac- 
counts receivable).  Our  entry  for  depreciation  has,  in  a  sense, 
put  a  label  on  our  assets  and  tagged  them  as  partly  "conversion 
of  machinery  or  other  productive  property,  available  for  replace- 
ment"; for  on  the  operating  statement  we  find  (unless  a  loss  has 
been  suffered)  converted  assets  jdelding  at  least  as  much  as  their 
cost  including  depreciation,  and  we  find  that  the  balance  sheet  is 
in  balance  even  with  the  writing  off  of  the  depreciated  asset  or 
setting  up  of  an  allowance.  If  the  balance  sheet  does  not  show  a 
deficit  or  other  shrinkage  of  proprietorship  through  loss,  does 
show  a  shrinkage  in  the  depreciated  property  or  an  allowance  to 
represent  it,  and  is  in  balance,  the  depreciated  property  must  have 
converted  itself  into  other  assets  and  those  assets  must  be  in  the 
business  —  else  the  assets  would  not  equal  the  ownership-claims. 
This  is  so  important,  and  is  so  often  misunderstood,  that  a  series 
of  summary  entries  to  indicate  the  process  of  conversion  is  worth 
while. 
Entries  for  Conversion  Operations.    Suppose  a  business  which 


308  THE  FUNDAMENTALS  OF  ACCOUNTING 

utilizes  machinery  and  chances  to  be  conducted  without  profit 
starts  a  year  with  the  following  simple  balance  sheet. 

Cash                         $  5,000  Accounts  Payable     $  8,000 

Accounts  Receivable    18,000  Proprietor                   55jOoo 

Machinery  40,000  

$63,000  $63,000 

Suppose,  to  make  the  illustration  a  severe  test  of  the  principle, 
that  in  the  following  period  not  all  bills  are  collected.  Using  the 
simplest  possible  transactions  for  a  year's  operations,  but  trans- 
actions nevertheless  typical,  we  may  have  the  following  entries. 

Purchases/Cash  20,000 

Expenses/Cash  S,ooo 

Depreciation/Machinery  1,000 

Accounts  Receivable/Sales  26,000 

Cash/Accounts  Receivable  25,500 

Loss  and  Gain/Purchases  20,000 

Loss  and  Gain/Expenses  5,000 

Loss  and  Gain/Depredation  1,000 

Sales/Loss  and  Gain  26,000 

Supposing  we  now  have  no  inventories  or  accrued  items,  we  get 
the  following  balance  sheet. 

Cash  $  5,500  Accounts  Payable  $  8,000 
Accounts  Receivable  18,500  Proprietor  55,ooo 
Machinery  39,000  

$63,000  $63,000 

We  observe  at  once  that  both  total  assets  and  proprietorship  are 
intact.  Where  is  the  property  available  for  replacing  the  machin- 
ery? It  lies  in  the  increase  of  cash  and  of  accounts  receivable. 
The  fact  that  the  balance  sheet  still  is  in  balance,  without  a  deficit 
or  shrinkage  in  proprietorship,  shows  that  the  assets  have  not  de- 
clined and  hence  the  means  of  replacement  must  be  there  some- 
where. A  part  of  the  machinery  has  been  literally  converted  into 
cash  and  accounts  receivable.  Quite  the  same  thing  would  be 
true  if  for  the  credit  to  Machinery  we  had  substituted  a  credit  to 
Allowance  for  Depreciation.  Our  balance  sheet  would  then  have 
been  $1,000  bigger  on  each  side,  but  both  sides  would  have  been 
statistically  padded,  so  to  speak  —  by  the  overvaluation  of  ma- 
chinery on  one  side  and  the  allowance  on  the  other.    It  would  still 


DEPRECIATION  AND  MAINTENANCE  309 

be  true,  however,  that  assets  for  replacement  are  in  the  business 
and  shown  on  the  balance  sheet,  for  after  allowing  for  the  padding 
the  assets  are  as  valuable  as  before  the  conversion. 

Special  Provision  for  Replacement.  We  have  seen  that  if  de- 
preciation is  not  neglected  in  the  accounts  and  loss  has  not  been 
suffered  and  capital  has  not  been  withdrawn,  assets  must  be 
available  for  replacement.  A  further  precaution  must  be  taken, 
however  —  that  at  the  time  replacement  becomes  necessary  the 
assets  into  which  the  old  property  has  been  converted  shall  be 
liquid  enough  to  serve  for  replacement.  If  machinery  in  a  mill 
has  been  gradually  depreciated  and  the  converted  assets  accumu- 
lated, and  then  those  converted  assets  have  been  invested  in  a 
new  dam  for  the  mill,  the  property  of  the  mill  as  a  whole  is  intact; 
but  the  machinery  cannot  be  replaced  from  the  dam,  and  hence 
one  kind  of  fixed  property  has  been  converted  into  another  kind 
of  fixed  property  and  replacement  of  the  first  is  now  impossible 
out  of  the  converted  property,  except  after  another  long,  and  this 
time  a  very  long,  new  conversion.  Watchfulness  is  required  to 
make  sure  that  lines  are  laid  to  have  liquid  assets  available  when 
needed.  The  surest  way  to  do  this,  of  course,  is  to  set  aside 
assets  year  by  year  in  a  special  fund  for  replacement.  This  usu- 
ally is  done  by  buying  securities  that  are  readily  saleable  and 
debiting  them  to  Replacement  Fund  Securities.  Then  we  have 
on  our  balance  sheet  the  provision  for  replacement  specially  la- 
beled, whereas  the  other  method  leaves  it  as  an  indistinguishable 
part  of  general  assets  indicated  only  by  the  fact  that  an  allowance 
has  been  set  up  (a  rather  inconspicuous  label)  or  that  the  fixed 
property  account  has  been  written  down  (virtually  an  invisible 
label).  The  main  objection  to  the  setting  aside  of  a  replacement 
fund  is  that  usually  a  business  can  earn  larger  income  with  capital 
that  it  utiKzes  in  its  own  operations  than  with  what  it  lends  or 
invests  outside,  and  that  therefore  it  may  at  the  same  time  accu- 
mulate a  replacement  fund  and  earn  an  extra  profit  by  applying 
its  converted  assets  to  its  own  direct  activities.  When  care  is 
taken  that  the  funds  be  not  too  much  tied  up,  this  is  often  good 
policy. 

When  No  Replacement  is  Contemplated.  Sometimes  replace- 
ment is  impossible  because  supply  of  the  asset  is  limited  and  no 


310  THE  FUNDAMENTALS  OF  ACCOUNTING 

more  can  be  had.  This  is  notably  true  of  mines,  quarries,  oil 
wells,  etc.  These  convert  so-called  *'  wasting  assets."  Opera- 
tions consist  primarily  in  exhausting  the  assets  and  only  wasteful 
expense  could  be  involved  in  putting  new  assets  back.  In  such 
industries  depreciation  is  a  specially  important  element.  If  it  is 
neglected,  when  proprietors  get  back  their  capital  in  the  product 
they  will  think  they  are  getting  profits,  and  when  the  property  is 
exhausted  they  will  suddenly  wake  to  the  fact  that  not  only  have 
profits  stopped  but  capital  has  disappeared.  If,  on  the  other 
hand,  depreciation  is  properly  recorded  (in  this  case  it  is  usually 
called  ''depletion"  —  to  show  that  not  only  value  but  physical 
property  itself  has  disappeared),  at  the  end  of  each  period  the  ac- 
counts will  make  evident  the  fact  that  an  appreciable  part  of  the 
assets  are  mere  conversions  and  not  profits.  If  the  business  can- 
not well  use  these  converted  assets  for  expansion,  it  will  usually 
distribute  them  to  owners;  but  the  managers  should  leave  no 
stone  unturned  to  make  clear  to  owners  that  a  part  of  the  dis- 
tribution is  capital  and  not  profits. 

Secret  Reserves.  The  contrary  of  the  error  discussed  in  the 
preceding  paragraph,  making  insufficient  charge  for  depreciation, 
results  in  what  is  commonly  called  a  "  secret  reserve."  This  will 
result  equally,  however,  from  excessive  charges  to  Maintenance. 
Suppose  in  the  case  given  on  page  301,  with  estimated  wear  and 
tear  at  $12,000,  repairs  at  $3,000,  and  replacements  at  $10,000, 
the  whole  $13,000  of  repairs  and  replacements  had  been  charged 
to  operations  and  none  to  betterments.  If  the  estimate  of  wear 
and  tear  is  correct,  some  facts  are  hidden:  profits  have  been  un- 
derstated, for  $1,000  of  the  outlay  was  not  consumed  in  making 
the  product  of  the  year;  and  assets  have  been  understated,  for 
$1,000  of  betterments  have  not  been  reported  among  the  assets. 
A  part  of  the  profits  (both  the  credit  to  proprietorship  and  the 
debit  to  the  asset  account)  are  secret.  Being  secret,  they  are  re- 
served from  distribution:  hence  the  name.  Any  overstatement  of 
expenses,  with  consequent  understatement  of  assets  (for  the  as- 
sets are  deemed  to  have  disappeared  when  they  are  still  existent) 
establishes  a  secret  reserve. 

What  is  Maintenance?  We  have  observed  that  treating  as 
nominal  (depreciation  or  maintenance)  what  should  be  treated  as 


'  DEPRECIATION  AND  MAINTENANCE  3 1 1 

real  creates  a  secret  reserve.  We  have  also  seen  that  the 
converse  is  true  —  treating  as  an  asset  what  has  been  consumed 
overstates  profits  and  leaves  a  secret  hole  or  overvaluation  in 
the  assets.  Yet  both  of  these  are  often  unwittingly  done.  If 
error  is  made  in  determining  whether  the  replacement  just  off- 
sets the  depreciation,  either  a  secret  reserve  or  a  secret  over- 
statement of  assets  will  be  involved  in  the  records.  What  is  it  to 
replace  or  maintain  property  that  has  been  exhausted?  Is  it  to 
maintain  the  power  to  produce  commodities  and  services;  is  it  to 
maintain  the  productivity  in  value  of  commodities  and  services; 
is  it  to  maintain  the  market  value  of  the  assets;  is  it  to  maintain 
the  earning  capacity,  or  profit-producing  capacity;  or  is  it  to 
maintain  the  value  invested  or  locked  up  in  the  plant?  If  main- 
tenance means  replacement  of  productive  capacity,  a  change  in 
prices  means  that  it  may  cost  $1,200  to  replace  a  machine 
originally  costing  $1,000,  and  the  charge  to  Maintenance  should 
be  $1,200.  If  maintenance  means  replacement  of  market  value, 
a  change  in  prices  that  puts  what  was  formerly  a  $1,000  machine 
at  $1,200  means  that  when  a  new  machine  takes  the  place  of  the 
old  a  debit  may  be  made  to  Maintenance  for  $1,000  and  to  the 
asset  account  for  $200;  for  not  only  has  the  market  value  of  the 
assets  risen  $200,  so  that  the  asset  account  should  be  increased, 
but  only  $1,000  was  needed  to  maintain  the  market  value  of  the 
property.  If  maintenance  means  replacement  of  earning  ca- 
pacity, a  change  in  competition  may  mean  that  whereas  pre- 
viously a  $1,000  machine  earned  profits  of  $200  a  year  now  it 
takes  $1,200  of  machinery  to  earn  $200  a  year,  and  the  $1,200 
spent  to  replace  the  old  $1,000  must  be  charged  to  Maintenance. 
If  replacement  means  replacement  of  investment,  an  increase  in 
price  of  a  machine  from  $1,000  to  $1,200  means  that  when  replace- 
ment is  made  $1,000  will  be  charged  to  Maintenance  and  $200  to 
assets,  as  an  addition  to  capital.  These  various  interpretations  of 
maintenance  thus  give  differing  figures  for  the  balance  sheet  and 
for  the  income  sheet. 

Charging  against  Revenue  and  Charging  to  Capital.  Charging 
to  Maintenance  is  commonly  called  '*  charging  to  revenue,"  or 
more  properly  "charging  against  revenue,"  for  maintenance  is 
counted  as  an  operating  cost  and  must  be  met  out  of  the  revenue 


312  THE  FUNDAMENTALS  OF  ACCOUNTING 

of  the  period;  but  charging  to  the  asset  account  is  called  "  charg- 
ing to  capital,"  for  it  assumes  that  the  expenditure  involves  an 
addition  to  the  property  or  capital  in  the  business.  It  is  obvious 
that  the  total  expenditure  on  account  of  replacement  of  property 
must  be  charged  either  to  Maintenance  or  to  the  asset  account; 
for  unless  the  expenditure  is  wasted  it  replaces  old  property  not 
written  down,  or  adds  property  (either  replacing  property  already 
written  down,  or  adding  new  property).  Since  Maintenance  is 
only  temporary  or  statistical,  and  the  balance  sheet  is  the  final 
destination  of  all  figures,  we  are  concerned  primarily  with  the 
effect  of  these  various  points  of  view  upon  that  sheet.  If  we 
charge  to  capital,  i.e.,  to  the  asset  account,  the  effect  of  replace- 
ment on  the  balance  sheet  is  a  change  in  the  form  of  assets  (e.g., 
machinery  instead  of  cash) ,  but  proprietorship  is  not  affected.  If 
we  charge  against  revenue,  i.e.,  to  Maintenance,  we  assume  that 
the  replacement  has  merely  restored  property  converted,  is  a  cost 
and  a  reduction  in  proprietorship  —  or  an  offset  to  what  otherwise 
would  be  increases  in  proprietorship  coming  through  the  yield 
from  converted  assets.  So  the  entry  which  charges  to  capital 
leaves  proprietorship  unchanged,  and  that  which  charges  against 
revenue  reduces  proprietorship  below  what  it  would  be  if  the  re- 
placement had  not  been  necessary;  and  it  makes  no  difference 
whether  we  think  in  terms  of  assets  or  in  terms  of  proprietorship, 
for  they  are  two  aspects  of  the  same  thing.  Whether  we  shall 
charge  to  capital  or  against  revenue  is  determined  by  the  basis  of 
capitalization;  for  this  decides  what  shall  be  charged  to  capital, 
and  the  rest  of  the  expenditure  for  replacement  is  charged  against 
revenue. 

Three  Bases  of  Capitalization.  The  term  *^  capitalization  "  has 
many  uses,  as  "  total  issue  of  capital  stock,"  "  total  investment  — 
capital  stock  and  bonds  issued,"  and  ''  book  figure  of  assets."  We 
are  here  concerned  with  the  last  of  these  uses  only,  the  figure 
placed  upon  assets  in  books  of  account  and  in  reports.  This  is 
important,  of  course,  for  any  misunderstanding  is  likely  to  mis- 
lead —  mislead  as  to  profits,  as  to  investment,  as  to  the  rate  of 
profits,  as  to  solvency.  Hence  a  basis  for  capitalization  must  be 
clearly  defined.  Though  the  five  suggestions  as  to  the  possible 
meaning  of  maintenance  given  on  page  311  appear  to  offer  five 


DEPRECIATION  AND  MAINTENANCE  313 

points  of  view  with  respect  to  capitalization,  as  a  matter  of  fact 
the  first  two  constitute  engineering  rather  than  accounting  stand- 
ards and  hence  for  accounting  purposes  require  conversion  into 
dollars  and  cents  in  the  form  of  one  of  "the  other  three.  These 
other  three  are  more  or  less  accepted  bases  for  accounting  and 
need  examination.  Before  we  can  choose  between  them,  however, 
we  must  decide  what  we  wish  our  balance  sheet  to  show;  for 
though  commonly  the  three  bases  of  capitalization  give  the  same 
results  on  the  balance  sheet,  in  many  cases  they  produce  results 
widely  different. 

The  Function  of  the  Balance  Sheet.  We  have  seen  all  along 
that  all  debits  are  for  either  assets  or  ownership-claims,  and  that 
in  any  case  they  produce  their  effect  on  the  balance  sheet;  for  if 
they  are  for  direct  acquisition  of  assets  they  appear  directly  on 
the  sheet,  if  for  conversion  of  assets  they  appear  as  converted,  if 
for  losses  they  reduce  proprietorship,  and  if  for  payment  of  debt 
they  reduce  habilities.  It  follows,  therefore,  that  an  error  any- 
where gets  sooner  or  later  upon  the  balance  sheet  unless  compen- 
sated for  by  another  error  elsewhere,  and  that  therefore  unless 
there  are  compensating  errors  profits  cannot  be  right  unless  the 
balance  sheet  is  right.  To  say  that  we  must  choose  a  basis  for 
balance-sheet  figures,  therefore,  is  to  say  that  we  must  also  choose 
a  basis  for  profit  or  loss  figures.  The  uses  to  which  a  balance 
sheet  as  a  whole  are  commonly  put  are  four:  (i)  determining 
solvency,  in  which  case  the  assets  must  be  taken  at  the  value  at 
which  they  could  be  converted  for  the  purpose  of  paying  debt; 
(2)  determining  the  advisability  of  lending  the  business  money  or 
giving  it  credit  for  merchandise,  in  which  case  the  lender  is  con- 
cerned not  with  ultimate  convertibility  after  the  long  and  expen- 
sive processes  of  Kquidation,  but  with  the  assets  soon  available  for 
paying  the  debt;  (3)  determining  the  value  of  the  assets  not  for 
liquidation  but  for  the  uses  of  a  going  concern,  so  that  one  may 
see  the  present  value  of  what  is  now  utilized  in  the  business;  and 
(4)  determining  what  is  now  actually  invested  in  the  business  by 
its  owners,  irrespective  of  what  the  same  property  or  an  equally 
effective  property  would  cost  to-day  and  of  what  it  would  bring 
to-day  if  liquidated.  It  is  obvious  at  a  glance  that  no  balance 
sheet  can  naturally  serve  all  these  purposes  at  once,  for  they  are 


314  THE  FUNDAMENTALS  OF  ACCOUNTING 

conflicting.  The  first  and  the  last,  for  example,  are  commonly 
wide  apart:  every  one  knows  that  if  he  tries  to  force  property  on 
the  market  for  immediate  sale  it  is  likely  to  bring  much  less  than 
cost  —  for  people  must  be  offered  a  very  low  price  to  induce  them 
to  buy  what  they  are  not  now  seeking  to  buy.  Realizing,  then, 
that  no  balance  sheet  can  naturally  serve  all  these  purposes  at 
once,  we  must  choose  a  basis  and  realize  always  that  our  balance 
sheet  is  to  be  constructed  on  that  principle:  we  must  not  use  it  as 
if  it  were  constructed  on  some  other  principle.  Let  us  see  how  far 
a  balance  sheet  serves  these  uses,  or  any  of  them. 

The  Balance  Sheet  and  Solvency.  Although  the  balance  sheet 
has  much  value  as  an  indicator  of  solvency,  usually  it  cannot 
carry  one  far  toward  a  definite  conclusion.  Some  methods  of 
interpreting  balance  sheets  are  discussed  in  Chapter  XX;  but  the 
fundamental  fact  should  not  be  forgotten  for  a  moment  that  a 
large  part  of  the  assets  of  most  businesses  are  not  held  for  sale  or 
for  early  conversion,  that  if  they  were  put  on  the  market  and  sold 
they  would  bring  but  a  small  part  of  their  book  value,  and  that  to 
judge  solvency  by  sale  value  of  assets  is  to  neglect  an  important 
business  principle.  The  value  of  assets  to  a  going  concern  is  far 
greater  than  the  value  of  those  assets  at  a  forced  sale.  If  a  busi- 
ness should  put  on  its  balance  sheet  at  sale  value  the  items  of  real 
estate,  machinery,  equipment,  etc.,  that  it  had  just  bought  for 
conducting  operations,  it  would  begin  with  a  large  deficit;  for  the 
cash  which  it  had  just  given  up  would  far  exceed  the  value  to  be 
placed  on  the  books  in  its  place.  It  is  impossible,  therefore,  for 
books  to  give  a  balance  sheet  that  will  show  outright,  without 
qualifications  and  mental  adjustments  for  circumstances,  the 
liquidating  solvency  of  a  business,  unless  the  books  are  kept  on 
that  plan,  and  this  destroys  their  value  for  guidance  in  operations; 
and  since  operations  are  usual  and  liquidation  is  abnormal,  it  is 
better  that  books  should  be  kept  as  for  a  going  concern.  So  the 
needs  of  the  first  of  our  four  uses  of  a  balance  sheet  must  be  re- 
pudiated as  a  basis  for  capitalization. 

The  Balance  Sheet  as  Credit  Indicator.  When  the  balance 
sheet  is  used  for  guidance  in  determining  whether  credit  shall  be 
given  to  a  business,  virtually  the  same  principles  apply  as  when  it 
is  used  for  judging  solvency.    The  only  difference  is  that  a  smaller 


DEPRECIATION  AND  MAINTENANCE  315 

number  of  items  are  of  importance,  for  the  creditor  will  look  to 
specific  items  for  his  security  and  not  to  general  liquidation.  He 
will  expect  a  liberal  margin  of  safety,  and  will  never  in  his  own 
mind  use  balance-sheet  figures  as  they  stand:  he  will  wish  to  apply 
his  own  judgment  of  values  in  conversion,  for  the  purposes  of  his 
own  claim;  and  his  judgment  will  differ  from  another  man's.  So 
it  is  equally  impossible  to  keep  books  so  as  to  produce  a  balance 
sheet  exactly  suited  to  a  particular  use  as  a  credit  statement  with- 
out diverting  the  books  to  that  particular  use  and  destroying  their 
usefulness  for  other  purposes.  So  the  needs  of  the  second  of  our 
four  uses  for  a  balance  sheet  is  repudiated  as  a  basis  for  capitaliza- 
tion. 

The  Balance  Sheet  and  **  Going  Values."  The  third  use  of  the 
balance  sheet  is  to  show  the  value  of  the  business  as  a  going  con- 
cern, but  this  in  turn  has  two  aspects,  for  usually  two  such  values 
pertain  to  a  property  and  they  are  often  wide  apart.  Under  the 
first,  the  balance  sheet  shows  the  value  of  the  specific  assets  com- 
prising the  business,  but  looked  at  in  the  point  of  view  of  duphca- 
tion  rather  than  of  sale.  In  this  point  of  view  the  property  is 
worth  what  to-day  would  be  the  cost  of  dupHcating  it.  This  is 
often  spoken  of  in  connection  with  hearings  on  rates  charged  by 
public-utility  corporations.  Under  the  second,  the  balance  sheet 
tries  to  show  the  value  of  the  business  as  a  profit-yielding  enter- 
prise, and  considers  that  its  value  is  dependent  on  the  profits  that 
it  yields,  independently  of  the  sale  value  of  the  assets,  of  its  actual 
cost,  and  of  the  cost  of  dupHcating  it.  Each  of  these  gives  a 
recognized  basis  of  capitalization,  and  we  must  examine  them  to 
see  what  effect  each  produces  on  the  balance  sheet  and  how  serv- 
iceable each  is.  The  first  of  these,  endeavoring  to  keep  the  bal- 
ance sheet  representative  of  what  it  would  cost  to  duplicate  the 
business,  uses  what  is  commonly  called  the  "  cost-of-dupUcation 
basis,"  or  the  "  cost-of- reproduction  basis,"  of  capitalization. 
The  second  uses  what  is  called  the  '*  earning-capacity  basis." 

The  Application  of  the  Cost-of-Duplication  Basis.  Suppose 
that  we  have  ten  machines  which  will  last  ten  years  each,  and  as  a 
matter  of  policy  we  replace  one  machine  a  year  and  thus  maintain 
rather  than  depreciate  our  property.  The  replacement  of  one 
machine  offsets  the  depreciation  of  the  other  nine  —  the  addition 


3l6  THE  FUNDAMENTALS  OF  ACCOUNTING 

to  the  value  in  one  offsets  the  decrease  in  the  value  in  the  others. 
If  the  values  of  the  ten  had  been  written  down  before  replace- 
ment, the  replacement  would  be  charged  to  the  asset  account,  but 
we  assume  here  that  nothing  has  been  written  down  for  this  pe- 
riod, and  hence  the  charge  is  to  Maintenance.  Now  suppose  that 
for  machines  similar  to  those  which  originally  cost  $i,ooo  we  have 
to  pay  $1,200.  By  cost  of  duplication,  of  course,  we  mean  not 
the  cost  or  market  price  of  dupUcating  the  specific  property  held, 
for  that  is  often  impossible  as  well  as  undesirable,  but  the  cost  of 
dupHcating  the  productive  capacity  or  efficiency.  On  the  cost-of- 
duplication  basis  we  wish  our  balance  sheet  to  show  the  value  of 
our  productive  capacity,  and  now  with  the  increase  in  the  price  of 
the  machine  we  need  an  increase  in  the  balance-sheet  figure  for 
the  new  machine  over  the  old.  So  we  will  debit  Maintenance  for 
$1,000,  for  the  replacement  of  the  old  cost  (the  cost  of  the  old 
machine  worn  out),  and  the  asset  account  for  the  $200  added 
value  —  that  is,  $1,000  is  charged  against  revenue,  and  $200  to 
capital  not  only  because  we  have  actually  paid  $200  added  cost  of 
replacement,  but  because  anybody  else  would  have  to  pay  that 
sum  also  as  enhanced  market  price  if  he  were  to  try  to  duplicate 
our  productive  capacity.  Now  let  us  observe  what  we  have  ac- 
complished. The  new  machine  is  on  our  books  at  replacement 
value;  but  all  property  not  recently  replaced  is  still  on  at  old  val- 
ues. In  other  words,  either  our  balance  sheet  is  a  mixture  of 
bases,  with  some  at  replacement  values  and  some  at  old  values,  or 
else  we  must  adjust  all  our  old  values  to  present  replacement 
values.  The  only  way  we  can  increase  values  that  have  risen  is 
to  credit  some  gain  account;  but  thisi,  whether  we  credit  a  current 
or  an  accumulated  gain  account,  is  counting  chickens  before  they 
are  hatched  —  which  we  have  already  seen  in  Chapter  XVII  to 
be  highly  objectionable;  and  the  only  way  we  can  reduce  values  is 
to  debit  some  loss  account  —  but  we  have  suffered  no  loss  if  the 
property  is  still  doing  its  work.  As  we  have  already  seen  in  Chap- 
ter XVII,  moreover,  replacement  values  have  nothing  to  do  with 
profits  and  losses.  Increases  and  decreases  in  replacement  values 
affect  the  future  requirements  of  capital  for  continuance  in  busi- 
ness, but  they  cannot  affect  the  cost  of  producing  with  the  old 
property.    So  they  cannot  affect  losses. 


DEPRECIATION  AND  MAINTENANCE  317 

The  Futility  of  the  Cost-of-Duplication  Basis.  Every  apprecia- 
ble change  in  the  cost  of  labor,  of  material,  of  taxes,  etc.,  affects 
the  price  of  commodities,  and  hence  the  replacement  value  of  all 
fixed  property  as  well  as  of  all  salable  property.  Every  change 
in  the  rate  of  wages,  and  in  the  price  of  bricks,  of  lumber,  of  build- 
ers' hardware,  of  window  glass,  etc.,  changes  the  replacement 
value  of  all  brick  buildings  standing  at  the  time  of  the  change. 
Replacement  values  are  not  in  the  least  stable.  The  value  of 
machinery  changes  with  the  rate  of  wages,  with  the  price  of  iron, 
with  the  cost  of  fuel  to  melt  the  iron,  etc.,  etc.  Hardly  a  day 
passes  when  the  replacement  value  of  a  plant  of  large  size  is  not 
affected  by  market  changes.  To  attempt  to  have  the  books  show 
such  changes,  even  if  only  at  the  time  of  adjustment,  would  mean 
very  heavy  accounting  cost.  It  would  be  already  behind  the 
times,  moreover,  as  soon  as  done.  Why,  then,  try  to  do  it?  Be- 
cause we  wish  to  know  the  value?  Then  why  not  have  an  ap- 
praisal made  when  one  wishes  the  figures?  As  a  matter  of  fact, 
dupHcation  costs  can  hardly  be  calculated  from  the  books  in  any 
case,  for  books  do  not  usually  show  so  many  details  of  cost  of  fixed 
assets  that  one  can  apply  a  change  in  one  or  two  elements  to  the 
old  figures.  Imagine,  e.g.,  trying  to  determine  from  the  books 
the  effect,  on  the  value  of  a  building  twenty  years  old,  of  an  in- 
crease of  10%  in  wages.  Figures  adjusted  to  changing  market 
conditions  are  extremely  unreliable  without  appraisal,  for  few 
people  know  to  what  to  apply  the  changes.  Since  the  books 
cannot  keep  the  records  of  duplication  value  but  can  only  adjust 
for  them,  since  the  changes  are  not  due  to  transactions  of  the 
business,  since  the  figures  are  behind  the  times  almost  as  soon  as 
entered,  it  is  rather  absurd  to  enter  them  at  all.  In  other  words, 
the  figure  of  duplication  value  of  a  plant  cannot  be  got  from  the 
books  in  any  case,  is  of  only  momentary  value  when  put  upon 
the  books,  and  hence  if  any  other  basis  will  give  more  valuable 
permanent  information  that  other  basis  had  better  be  used. 

The  Application  of  the  Eaming-Capacity  Basis.  Let  us  turn 
now  to  the  other  method  of  showing  on  our  balance  sheet  the 
value  of  the  business  as  a  going  concern  —  considering  it  as  an 
earning  machine.  Under  the  eaming-capacity  basis,  if  a  machine 
costing  $1,000  were  replaced  by  a  machine  to  do  the  same  work  at 


3l8  THE  FUNDAMENTALS  OF  ACCOUNTING 

a  cost  of  $1,200,  the  charge  for  the  $1,200  would  depend  on  cir- 
cumstances. If  the  new  machine  was  judged  to  earn  no  more 
profit  than  the  old,  the  whole  $1,200  would  be  charged  against 
revenue,  so  as  to  avoid  increasing  the  capital  charge;  but  if  it 
were  deemed  more  productive  of  revenue  the  portion  deemed 
equivalent  to  the  old  earning  capacity  would  be  charged  to  Main- 
tenance and  the  excess  to  capital.  This  is  based  on  the  theory 
that  the  value  of  every  productive  agent  is  determined  by  the  re- 
lation between  its  earnings  and  normal  earnings:  if,  for  example, 
6%  interest  is  normal,  any  productive  agent  that  will  produce  $6 
earnings  is  worth  $100,  and  any  that  will  produce  $9  is  worth 
$150;  but  if  interest  is  5%,  any  agent  that  will  produce  $6  is 
worth  $120,  and  any  that  will  produce  $9  is  worth  $180.  This 
basis  finds  the  market  value  of  the  business  as  a  productive  agent 
rather  than  the  value  of  its  assets  as  replaceable  individual  enti- 
ties. If  this  principle  were  carried  out  logically,  any  replacement 
that  would  yield  in  earnings  more  than  the  capitalized  value  of  its 
cost  should  be  entered  on  the  books  at  more  than  cost:  that  is,  if 
the  old  machine  cost  $1,000  and  earned  $60,  but  the  new  cost 
$1,200  and  would  earn  $75,  the  charge  should  be  $1,000  to  Main- 
tenance and  $250  to  assets,  with  a  credit  of  $1,200  to  Cash  and  $50 
to  Surplus  (or  some  other  gain  account) ;  for  the  earnings  of  the 
new  are  one-fourth  greater  than  those  of  the  old  and  hence  the 
capitalized  value  should  be  one-fourth  greater.  In  practice,  how- 
ever, those  who  use  this  basis  usually  hesitate  to  charge  to  capital 
more  than  cost.  If,  then,  our  policy  is  to  replace  one  machine  a 
year  and  charge  the  replacement  to  Maintenance,  the  purchase  of 
a  $1,200  machine  to  replace  one  costing  $1,000  is  wholly  chargea- 
ble to  Maintenance  when  the  machine  will  earn  no  more,  is  charge- 
able $1,000  to  Maintenance  and  $200  to  the  asset  account  when 
the  machine  will  earn  one-fifth  more  (or  more  than  one-fifth 
more),  and  is  chargeable  somewhat  more  than  $1,000  to  Main- 
tenance and  somewhat  less  than  $200  to  the  asset  account  when 
the  earning  capacity  is  greater  but  not  one-fifth  greater. 

The  Futility  of  the  Earning-Capacity  Basis.  Just  as  with  the 
duplication  basis,  the  effort  is  not  worth  the  trouble.  Earning 
capacity  is  constantly  changing.  Either  a  part  of  the  assets 
(those  recently  acquired)  will  be  on  an  earning-capacity  basis  and 


DEPRECIATION  AND  MAINTENANCE  319 

the  others  will  not  (at  least  not  on  a  basis  of  present  earning  ca- 
pacity), or  all  values  must  be  readjusted  at  each  balance-sheet 
day  to  present  earnings.  Not  only  is  this  an  enormous  task  for 
each  piece  of  property,  but  it  is  fruitless;  for  the  earning  capacity 
of  the  whole  business  is  what  one  chiefly  desires  and  that  is  already 
shown  by  the  income  sheets.  Any  one  who  knows  very  elemen- 
tary arithmetic  can  give  a  capitalized  value  if  he  knows  the  rate  to 
use  and  the  gain  as  shown  by  the  income  sheet.  Even  if  one  were 
to  show  such  a  value  on  the  books,  moreover,  it  would  be  almost 
immediately  a  dead  letter.  Thus  with  the  earning-capacity  basis 
as  well  as  with  the  cost-of-duphcation  basis  we  find  the  task  of 
keeping  the  accounts  not  only  laborious  and  confusing,  but  futile, 
for  the  information  finally  incorporated  in  the  balance  sheet  can 
be  got  as  well  without  these  bases  as  with  them;  hence  these  bases 
should  be  abandoned  if  any  better  basis  can  be  found. 

The  Balance  Sheet  and  Actual  Costs.  We  have  seen  the  futil- 
ity of  the  balance  sheet  as  direct  indicator  of  solvency,  as  direct 
indicator  of  credit  standing,  as  indicator  of  cost  of  duplication,  as 
indicator  of  earning  capacity.  In  every  one  of  these  cases  at- 
tempt to  make  the  balance  sheet  serve  the  function  indicated 
makes  much  labor,  confuses  operating  figures,  and  finally  leaves 
the  function  no  better  performed  than  if  the  attempt  had  not  been 
made  through  the  balance  sheet  at  all.  The  remaining  suggested 
function  of  the  balance  sheet  is  to  show  what  the  proprietors  of 
the  business  have  now  invested  in  various  forms  of  assets,  irre- 
spective of  present  selling  or  duplication  values  and  of  earnings. 
This  is  done  by  what  is  called  the  ''actual-cost  basis." 

The  Application  of  the  Actual-Cost  Basis.  Unlike  the  other  two 
bases,  the  actual-cost  basis  gives  us  a  definite  thing,  a  matter  of 
available  knowledge  independent  of  external  fluctuations,  and  it 
involves  no  extra  work  of  entry  —  that  is,  the  natural  entry  is 
that  on  the  cost  basis.  Reverting  to  our  illustration  of  annual 
replacement  of  one  machine  for  maintenance,  if  a  worn-out  $1,000 
machine  is  replaced  by  a  new  one  costing  $1,200,  we  are  not  con- 
cerned with  any  question  about  the  productivity  of  the  new  ma- 
chine, or  about  its  earning  capacity,  or  about  the  cost  of  the  old 
machine  which  it  replaces:  we  are  concerned  solely  with  the  cost 
of  the  new  and  its  relation  to  maintenance.    We  have  already 


320  THE  FUNDAMENTALS  OF  ACCOUNTING 

determined  that  wear  and  tear  amounts  to  $i,ooo  a  year  for  this 
group  of  machines.  Since  the  new  machine  costs  $1,200,  we  have 
replaced  the  wear  and  tear  and  have  added  to  our  investment 
$200.  So  we  debit  Maintenance  $1,000  and  the  asset  account 
$200.  This  is  in  accord  with  the  historical  facts,  moreover:  our 
former  investment  was  $1,000,  and  our  present  investment  $1,200 
as  the  books  show.  If  the  new  machine  for  replacement  cost  only 
$800,  we  should  charge  Maintenance  $800  only  and  Depreciation 
$200  —  the  latter  having  for  its  complement  either  a  writing 
down  of  the  asset  account  or  an  increase  in  the  Allowance  for  De- 
preciation; and  this  would  be  true  whatever  its  earning  capacity, 
for  we  have  failed  by  $200  to  replace  the  wear  and  tear. 

The  Value  of  the  Actual-Cost  Basis.  The  cost  basis  gives  us 
historical  facts.  The  asset  accounts  represent  on  this  basis  what 
the  proprietors  have  in  the  business  —  what  they  have  actually 
put  in  and  have  not  yet  got  out  by  withdrawal,  or  by  depreciation 
or  other  conversion.  Under  this  method  the  balance  sheet  has 
unity  —  all  figures  are  on  the  same  basis,  and  need  no  adjustment 
for  changes  in  market  prices  or  in  earning  capacity.  Since  the 
cost  basis  gives  a  figure  not  only  historically  worth  while  but  un- 
obtainable except  from  accounts  kept  strictly  on  the  actual-cost 
basis,  it  is  the  logical  method. 

An  Illustration.  Let  us  examine  by  a  few  cases  the  working  of 
the  actual-cost  basis.  We  will  suppose  that  (i)  a  machine  cost 
originally  $500;  (2)  its  estimated  life  was  four  and  a  half  years  and 
its  scrap  value  was  estimated  at  $50,  so  that  depreciation  was  put 
at  $100  a  year;  (3)  it  now  stands  on  the  books,  which  were  ad- 
justed six  months  ago  and  four  years  after  the  machine  was 
bought,  at  $100;  (4)  we  now  abandon  the  machine  and  exchange  it 
for  a  new  one,  just  like  it,  costing  $500,  but  we  get  an  allowance 
of  $50  for  the  old  one.  This  is  virtually  the  simplest  possible  case. 
The  books  now  show  $100  for  the  old  machine,  and  when  we  have 
installed  the  new  they  should  show  $500.  The  cash  which  we  pay, 
however,  is  only  $450.  The  simplest  entry  is  to  debit  the  asset  ac- 
count $400  (to  get  it  at  $500),  debit  Maintenance  $50  (for  the 
half-year's  depreciation  which  has  not  been  written  off  but  is  now 
offset),  and  credit  Cash  $450.  We  may,  however,  if  we  prefer, 
first  debit  Depreciation  for  the  six  months'  loss  of  value,  and  then 


DEPRECIATION  AND  MAINTENANCE  3  21 

charge  the  asset  account  (or  the  allowance)  for  the  full  $450  re- 
stored (for  the  $50  scrap  value  never  disappears  but  merely 
changes  its  form  from  the  old  machine  to  the  new) .  If,  however, 
we  change  our  supposition  and  suppose  the  new  machine  to  cost 
$600  ($550  in  cash  plus  the  surrender  of  the  old),  we  shall  charge 
the  asset  account  $500,  to  raise  it  from  the  $100  at  which  it  now 
stands  to  $600  (for  our  investment  is  now  $600),  and  Maintenance 
$50.  We  do  not  need  to  look  at  anything  but  the  plain  facts  of 
the  case,  uninfluenced  by  considerations  of  earning  capacity  or 
previous  market  value:  we  merely  charge  Maintenance  for  the 
replacement  of  shrinkage  of  value  since  the  books  were  last  ad- 
justed, and  charge  the  asset  account  for  the  rest  of  our  payment. 
The  fact  that  the  old  machine  cost  $500  does  not  enter  into  our 
consciousness  at  the  time  of  making  the  entry;  for  that  has  been 
taken  care  of  automatically  by  the  depreciation  charges  of  other 
years.  If  we  now  buy  the  new  machine  for  $400  ($350  cash),  our 
debit  to  Maintenance  is  $50  as  before,  but  our  debit  to  the  asset 
account  is  but  $300.  This  automatically  puts  the  asset  on  the 
books  at  $400,  which  is  what  we  now  have  in  the  machinery. 

A  Second  Illustration.  Suppose  a  case  similar  to  the  above 
except  that  when  the  property  has  been  held  for  two  years  and 
has  been  depreciated  to  $300  only,  a  change  in  the  demand  for 
commodities  throws  this  machine  out  of  use  and  it  is  replaced  by 
another  costing  $500  ($450  cash  and  $50  allowance  for  the  old 
machine).  Shall  the  machinery  stand  now  on  the  books  at  $750 
or  at  $500 :  shall  the  cost  of  the  new  be  added  to  the  book  value  of 
the  old,  or  shall  the  old  be  written  down  to  scrap  value  before  the 
new  is  added?  The  old  machine  has  had  its  turn,  it  has  done  its 
work  —  not,  to  be  sure,  the  work  expected  of  it  but  the  only 
work  available  for  it  to  do:  the  depreciation  and  obsolescence  on 
it  are  chargeable  to  its  product  and  hence  no  longer  represent  in- 
vestment. The  neglect  to  allow  enough  depreciation  in  the  two 
years  was  an  error  in  judgment  (such  as  all  business  is  subject  to) 
and  must  now  be  compensated  for  by  a  retroactive  charge  against 
surplus  or  some  similar  account,  as  will  be  discussed  in  the  next 
chapter;  and  it  should  not  be  carried  in  the  asset  account  even  on 
the  actual-cost  basis,  for  as  things  turned  out  the  depreciation 
was  suffered  for  the  product  of  two  years.    The  entry  for  replace- 


322  THE  FUNDAMENTALS  OF  ACCOUNTING 

ment  would  then  be  a  debit  to  Surplus  for  $250  (to  correct  the 
estimate  of  life  of  the  old  machine),  and  to  the  asset  account  for 
$200  (to  increase  it  to  the  cost  of  the  new  machine),  and  a  credit 
to  Cash  for  $450.  Losses  of  property  from  operation  should  be 
recognized  on  the  balance  sheet  by  a  reduction  in  the  accounts 
representing  the  assets  lost,  just  as  the  losses  will  show  on  the 
income  sheet  and  in  the  reduction  in  proprietors'  accounts. 

Another  Illustration.  Suppose,  finally,  at  the  end  of  two  years 
of  the  Ufe  of  the  machine,  when  it  has  been  depreciated  to  $300  as 
in  the  last  case,  the  legislature  passes  a  law  forbidding  the  use  of 
this  machine  because  (on  account  of  the  carelessness  of  employees) 
it  has  been  found  generally  dangerous  in  use  (though  we  have 
taken  such  precautions  that  we  have  had  no  accidents).  We  now 
are  forced  to  abandon  it  and  to  buy  another,  perhaps  costing  $600. 
Shall  the  cost  of  the  new  be  added  to  the  unrecovered  value  of  the 
old,  making  the  ledger  figure  $900,  or  shall  the  new  stand  at  $600, 
with  the  other  $300  charged  to  Surplus  or  some  similar  account 
provided  for  emergencies  ?  It  should  in  any  case  be  clear  that  the 
$300  shrinkage  in  value  because  of  the  act  of  the  legislature  is  not 
chargeable  to  the  current  period  alone.  What  is  the  actual  amount 
of  the  present  investment?  It  is  the  unrecovered  value  of  the  old 
machine,  $300,  plus  the  additional  payment  for  the  new,  $600;  for 
the  investment  of  the  proprietors  has  never  been  wholly  recovera- 
ble from  the  old.  The  facts  regarding  the  old  are  now  different 
from  those  under  our  second  case.  In  the  second  case  the  natural 
course  of  events  shortened  the  life  of  the  machine,  and  therefore 
increased  the  charge  for  each  year  of  its  use,  and  the  invested 
capital  had  its  opportunity  to  recoup  itself  in  the  product  through 
conversion.  If  it  did  not  do  so,  the  business  showed  a  loss,  as  it 
should.  In  this  third  case,  however,  the  business  was  prevented 
by  causes  external  to  the  natural  course  of  events  from  recovering 
its  capital  through  conversion:  capital  put  in  was  rendered  unre- 
coverable not  by  the  operations  of  business,  which  the  capital  was 
invested  to  endure,  but  by  legislative  interference.  A  part  of  the 
capital  has  never  been  got  out,  and  hence  as  actual  cost  it  is  still 
there  —  though  as  salable  assets  it  no  longer  exists.  This  is 
what  is  meant  by  the  actual-cost  basis  —  what  has  been  put  into 
assets  and  has  not  yet  been  withdrawn  or  utilized  in  operations. 


DEPRECIATION  AND  MAINTENANCE  323 

Actual-Cost  Basis  Misused.  As  all  accounting  is  matter  for 
judgment  and  not  for  rules  of  thumb,  care  must  be  taken  not  to 
abuse  the  actual-cost  basis  and  deem  to  be  cost  what  is  not  cost. 
The  last  two  cases  given  occupy  border  territory,  and  it  is  easy 
to  say  that  if  the  replacement  is  not  to  be  capitalized  when  it  is 
necessitated  by  a  change  in  customs  of  the  public,  it  should  not 
be  capitalized  when  it  is  necessitated  by  an  act  of  legislation.  In 
each  case  the  failure  to  get  the  expected  use  out  of  the  machinery 
was  due  to  a  cause  outside  of  the  business  itself:  but  in  the  first  of 
these  cases  it  was  in  accord  with  the  very  nature  of  business  and 
was  one  of  the  elements  of  cost  of  operations  (as  obsolescence 
always  is) ;  and  in  the  other  case  it  was  an  abnormal  interference 
with  the  natural  laws  of  this  business  (for,  by  supposition,  in  this 
establishment  the  protection  of  employees  did  not  require  it, 
though  it  may  have  been  generally  required)  by  which  the  public, 
through  its  representatives,  without  sufficient  warning  prevented 
this  business  from  utilizing  to  the  full  its  former  capital  and  thus 
required  of  it  more  capital  —  a  proper  ground  for  an  increased 
charge  to  capital  as  indicating  what  the  proprietors  now  have  as 
investment  in  the  business.  This  is  very  different,  however,  from 
defending  the  capitalization  of  costs  unduly  high  because  of  care- 
lessness or  fraud.  By  "actual  cost"  in  this  connection  is  meant 
actual  cost  of  what  is  got  —  but  if  through  carelessness  or  fraud 
payment  is  made  for  more  than  was  got,  the  excess  payment  is  not 
cost  at  all,  and  should  not  be  charged  to  capital.  If,  on  the  other 
hand,  the  best  obtainable  judgment  was  employed  and  no  neglect 
or  fraud  was  involved  on  the  part  of  those  responsible  for  the 
work  or  purchase,  the  payment  constitutes  actual  cost  and  may  on 
this  basis  be  charged  to  capital,  even  though  later  events  show  that 
some  innocent  bad  judgment  was  used.  In  one  sense  we  may  say 
that  the  purpose  of  the  actual-cost  basis  is  to  show  the  pro- 
prietors their  actual  investment  so  that  they  may  judge  whether 
their  profits  are  reasonable.  They  could  hardly  expect  a  return 
in  the  form  of  profits  on  money  which  they  had  thrown  away  by 
carelessness  or  fraud;  but  they  can  expect  a  reasonable  return  on 
investment  which  the  public  by  legislation  has  prevented  them 
from  utilizing  to  full  conversion.  Losses  from  operation,  too,  y^ 
should  not  be  confused  with  investment  and  transferred  as  cost  of 


324  THE  FUNDAMENTALS  OF  ACCOUNTING 

assets;  for  though  it  is  true  that,  if  the  owners  of  the  business 
have  suffered  losses  (or  even  profits  lower  than  normal),  they  may- 
expect  to  have  these  recouped  and  may  consider  them  a  sort  of 
claim  on  the  future,  the  place  to  look  for  profits  or  losses  is  not 
the  balance  sheet,  but  the  income  sheet,  and  inadequacy  of  returns 
on  investment  should  not  be  consolidated  with  actual  cost  of  in- 
vestment —  especially  since  difference  of  opinion  may  exist  as  to 
what  constitutes  adequate  return,  and  matters  of  opinion  should 
not  be  consolidated  in  the  same  accounts  with  matters  of  fact. 

Common  Ground  of  the  Three  Bases.  It  should  be  noted  that 
the  common  sort  of  transaction  requires  the  same  treatment  un- 
der all  three  bases  of  capitalization.  Under  normal  economic  con- 
ditions, most  replacements  when  they  exceed  in  actual  cost  the 
property  replaced  bring  both  increased  earning  capacity  and 
increased  duplication  value,  and  then  no  problem  arises.  That 
is  why,  as  a  matter  of  fact,  one  should  be  alert  to  follow  a  settled 
policy,  lest  in  cases  of  difference  one  may  by  inadvertence  make 
some  entries  on  one  basis  and  others  on  another,  thus  producing 
accounts  that  as  a  whole  mean  neither  one  thing  nor  another. 

Public  Interest  in  Capitalization.  Of  late  years  much  public 
discussion  has  sprung  up  over  the  bases  of  capitalization,  for  most 
states  have  passed  laws  for  the  regulation  of  the  charges  of  public- 
service  corporations  and  question  arises  as  to  the  basis  for  rea- 
sonable rates.  All  three  of  the  bases  of  capitalization  just  dis- 
cussed, to  say  nothing  of  variants  and  combinations  of  them,  have 
been  used  for  determining  reasonable  rates.  It  should  be  ob- 
served, however,  that  the  purpose  of  accounting  is  quite  as  much 
to  furnish  a  guide  for  the  operation  of  the  business  as  to  furnish 
a  basis  for  reasonable  rates;  and  as  we  have  seen  already  that  both 
cost  of  duplication  and  earning  capacity  can  be  learned  as  well 
when  they  are  not  used  as  the  basis  of  the  accounting  as  when  they 
are  so  used,  the  purposes  of  rate-making  cannot  require  them  on 
books  of  account.  The  choice  between  bases  for  rate  making  is  a 
matter  of  public  policy  rather  than  of  accounting.  Allied  to  it  is 
the  pubHc  interest  in  the  question  as  to  whether  rates  should 
be  based  on  original  value  of  property  or  on  depreciated  value, 
which  again  is  a  matter  of  public  policy  rather  than  of  account- 
ing.   For  both  of  these  important  matters,  however,  accounting 


DEPRECIATION  AND  MAINTENANCE  325 

must  furnish  the  facts  on  which  a  decision  is  reached,  for  justice 
cannot  be  assured  without  a  knowledge  of  what  has  actually- 
happened. 

Depreciation  of  Merchandise.  Our  discussion  of  depreciation 
up  to  this  point  has  used  more  or  less  fixed  assets  for  illustration 
—  assets  not  exhausted  with  one  use.  One  should  realize  that 
merchandise  and  other  property  acquired  for  early  sale  but  carried 
over  from  one  period  to  another  raise  new  considerations.  When 
the  same  merchandise  is  carried  over  several  periods,  it  is  subject 
to  the  sort  of  depreciation  that  we  have  been  discussing  —  grad- 
ual deterioration  by  shop  wear  or  handling,  and  obsolescence. 
When  it  is  carried  over  only  from  one  period  to  the  next  (as  some 
must  be  carried  unless  one  is  to  discontinue  business  at  least 
temporarily  at  the  end  of  each  earning  period),  depreciation  may 
sometimes  be  taken  once  for  all  and  never  recur.  Suppose  we 
begin  business  with  a  new  stock  of  goods  costing  $30,000  and 
replenish  it  as  fast  as  sold,  and  therefore  at  the  end  of  the  period 
have  an  inventory  (at  cost  prices)  of  $30,000.  Some  of  this  stock 
is  deteriorated,  of  course,  at  least  slightly,  for  in  order  to  satisfy 
customers  we  must  carry  more  varieties  of  stock  than  are  actually 
called  for  and  the  uncalled-for  items  become  obsolete  or  shop- 
worn. Suppose  we  debit  Depreciation  of  Merchandise  $1,000, 
and  credit  Allowance  for  Depreciation  of  Merchandise,  to  cover 
this  deterioration.  The  Depreciation  will  be  closed  to  the  clearing 
account.  Suppose  for  the  next  period  we  do  as  before  and  again 
have  an  inventory  at  cost  prices  of  $30,000.  What  shall  we  do 
about  depreciation?  Shall  we  make  another  debit  for  $1,000? 
If  so,  we  shall  have  an  allowance  of  $2,000  on  a  stock  of  $30,000, 
whereas  a  year  ago  we  had  an  allowance  of  only  $1,000  on  a  stock 
of  $30,000.  Do  we  need  more  now  than  then?  Not  unless  the 
stock  is  poorer  than  it  was  at  the  end  of  the  last  period,  which 
is  contrary  to  our  supposition.  Then  we  are  in  error.  We  do  not 
need  any  depreciation  for  the  second  period.  We  have  main- 
tained our  stock  at  the  average  age  that  it  had  before;  but  we  have 
not  charged  anything  to  Maintenance,  because  maintenance  is 
automatically  taken  care  of  through  purchases.  A  part  of  our 
purchases  replaces  the  value  of  goods  sold,  and  a  part  replaces  the 
depreciation  on  goods  not  sold.     Only  in  case  the  condition  of 


326  THE  FUNDAMENTALS  OF  ACCOUNTING 

deterioration  of  stock  is  worse,  or  in  case  an  increase  in  the  total 
stock  carried  requires  a  larger  allowance,  is  a  charge  for  deprecia- 
tion necessary  a  second  time:  maintenance  has  prevented  depre- 
ciation. If,  on  the  other  hand,  less  allowance  is  necessary  be- 
cause the  stock  is  less  deteriorated  or  is  smaller,  a  debit  may  be 
made  to  the  Allowance  for  Depreciation  of  Merchandise,  reducing 
it.  This  necessitates  a  very  careful  handling  of  the  allowance 
account,  the  complementary  account,  and  the  clearing  account 
for  merchandise,  producing  a  complication  too  confusing  to  be 
worth  study  here.  The  escape  from  this  confusion  is  to  avoid 
any  allowance  for  depreciation  of  merchandise  and  to  carry  the 
inventory  at  depreciated  value  only.  Indeed,  since  the  mer- 
chandise is  intended  for  quick  conversion,  the  establishment  of 
an  allowance  is  usually  an  unnecessary  statistical  refinement 

QUESTIONS  AND  PROBLEMS 
I.  The  balance  sheet  of  a  business  is  as  follows; 


Real  Estate 

$10,000 

Proprietor 

$25,000 

Accts.  Receivable 

20,000 

Accts.  Payable 

18,000 

Merchandise 

14,000 

Profits 

6,000 

Cash 

5,000 

$49,000  $49,000 

Competent  engineers  estimate  that  an  annual  expenditure  of  $1,000 
Mrill  offset  wear  and  tear  and  obsolescence  of  real  estate.  Assuming 
that  there  are  no  changes  in  the  business  except  those  resulting  from 
the  policy  respecting  real  estate  as  indicated  below  (for  there  are  no 
profits  or  losses),  show  journal  entries  and  the  balance  sheets  for  each 
of  the  following.    Do  not  write  down  the  plant. 

(a)  In  the  first  year  $1,000  is  spent  for  maintenance. 

(b)  In  the  second  year  $500  is  spent  for  maintenance,  and  $500  in 
cash  is  set  aside  as  a  depreciation  fund. 

(c)  In  the  third  year  $1,200  is  spent  for  maintenance,  and  the  real 
estate  is  then  found  to  be  in  its  original  condition  and  of  its  original 
value. 

2.  A  business  bought  property  for  $3,000,  and  estimated  the  annual 
charge  for  maintenance  at  $300.  During  the  first  year  it  spent  $300  for 
maintenance.  During  the  second,  it  spent  only  $200.  During  the 
third,  it  spent  $400.  Below  imder  A  is  the  way  the  accountant  handled 
the  items.  Under  B  is  the  way  the  manager  told  him  the  accounts 
should  have  read.  Decide  between  them,  compromise,  or  suggest 
another  way,  as  you  see  fit. 


DEPRECIATION  AND  MAINTENANCE 


327 


A 

Bal.  Sheet 
Beginning     Property 

1  year  later        " 

2  years    "         " 

3  " 


Income  Sheet 
ist  year      Maint. 
2d      "     J  ^^"'*- 

3d 


{  Deprec. 
Maint. 


$3,000 
3,000 
2,900 
3,000 


$300 
200 
100 
300 


B 

Bal.  Sheet 

Beginning     Property  $3,000 

I  year  later         "  3,000 

5  Property  3,000 
(  Res.  Deprec.     100 

Property  3,000 


2  years 

3  " 


ist  year 
2d     " 
3d     " 


Income  Sheet 
Maint. 


$300 
200 
400 


The  wear  and  tear  of  equipment  was  estimated  to  be  $1,500  annually, 
and  no  reason  has  been  found  for  questioning  the  accuracy  of  the  figures. 
In  1 91 6  the  amount  spent  on  repairs  and  replacements  was  $1,200,  in 
1917  it  was  $1,600,  in  1918  it  was  $1,300. 

The  several  income  sheets  showed  charges  with  respect  to  wear  and 
tear  of  equipment  as  follows: 


Maintenance 
Depreciation 

Maintenance 

Maintenance 
Depreciation 


1916 


1917 


igi8 


1,200 
300 


1,500 


1,500        1,500 


1,300 
200 


1,500 


The  several  balance  sheets  were  as  follows: 

Resources 


Equipment 
Receivables 
Other  Assets 

1/1/1Q16 
20,000 
45,000 
15,000 

1/1/ 1 917 
20,000 
45,000 
15,000 

1/1/ 1 91 8 
20,100 
45,000 
14,900 

1/1/1919 
19,600 
45,000 
15,100 

80,000 

80,000 

80,000 

79,700 

Liabilities 

Capital  Stock 
Payables 
Allowance  Deprec, 

1/1/ 1 916 
50,000 
30,000 

1/1/ 1 917 

50,000 

29,700 

300 

80,000 

i/j/1918 

50,000 

29,700 

300 

80,000 

1/1/1919 
50,000 
29,700 

80,000 

79,700 

Assume  that  all  profits  made  have  been  distributed  in  dividends, 
(a)  Are  the  income-sheet  figures,  as  given,  correct?    If  not,  show  what 
for  any  year  they  should  be. 

[Problem  continued  on  next  page. 


328  THE  FUNDAMENTALS  OF  ACCOUNTING 

(b)  Are  the  balance-sheet  figures  consistent  with  your  income-sheet 
figures  (after  you  have  corrected  any  errors  in  the  income  sheet)? 
If  not,  show  what  they  should  be;  but  do  not  change  any  figures  for 
mere  preference  of  form;  change  them  only  if  they  are  actually  in- 
consistent with  your  figures.  If  they  are  correct  as  they  stand, 
show  how  the  figures  for  1/1/1917  were  obtained  from  those 
of  1/1/1916,  and  those  of  1/1/1919  from  those  of  1/1/1918. 

4.  A  corporation  has  been  for  years  charging  to  revenue  what  it  might 
properly  have  charged  to  capital,  and  consequently  has  accumulated  a 
large  secret  reserve,  in  the  form  of  assets  not  shown  on  the  books,  and 
shows  no  surplus  on  the  books.  These  assets  have  been  currently  in- 
vested in  additional  machinery.  The  income  tax  authorities  discover 
this,  and  assess  back  taxes  on  the  unrevealed  income. 

What  entries  should  be  made  now  for  the  payment  of  the  taxes  and 
to  correct  the  books  and  to  protect  the  corporation  against  future  accu- 
sation of  attempt  to  defraud  the  government? 

5.  On  closing  the  books  at  the  end  of  the  year,  which  of  the  following  should 
you  carry  to  revenue  and  which  to  capital  accounts?  Give  your  reasons. 

(a)  A  sign  costing  $250  painted  on  the  outside  walls  of  a  building 
leased  under  tenancy  at  will. 

(b)  Repairs  costing  $1,000  on  a  building  two  years  old  which  had 
not  been  previously  repaired  but  was  depreciated  on  the  books  a 
year  ago  for  $500,  assuming  that  the  building  is  now  restored  to 
its  original  state. 

(c)  A  rebate  allowed  you  on  February  i  for  a  defect  found  by  you  in 
goods  bought  on  December  15  and  still  on  hand. 

(d)  A  dictating-machine  system  costing  $350  which  eliminates  the 
need  of  one  of  three  stenographers  who  receives  a  yearly  salary 
of  $1,000. 

(e)  Services  of  a  special  watchman  during  a  period  of  strike  riots. 

(f)  A  charge  of  $2,000  for  enlarging  a  factory  in  compliance  with 
a  new  building  law  requiring  a  fixed  amount  of  space  per  employee, 
if  the  enlarged  building  accommodates  no  additional  productive 
power. 

6.  Show  entries  for  the  following  purchase,  using  each  of  the  three  bases  of 
capitaHzation. 

An  office  automobile  is  purchased  for  $2,000  to  replace  an  old  auto- 
mobile, of  the  same  make  and  model,  when  the  old  cost  $1,500,  is  on  the 
books  at  $500,  and  has  an  exchange  value  of  $200  as  part  of  the  pur- 
chase price  of  the  new. 

7.  A  machine  which  costs  $200  is  estimated  to  have  a  life  of  five  years, 
at  the  end  of  which  it  will  have  a  scrap  value  of  $20.  Show  how  much 
the  machine  would  be  depreciated  each  year 

(a)  by  the  straight-Hne  method 

(b)  by  the  reducing-balance  method  (the  percentage  is  roughly  37) 

(c)  by  the  reducing-fraction  method 

In  calculating,  disregard  cents  except  for  finding  the  nearer  dollar. 


CHAPTER  XIX 

THE  DISPOSITION  OF  PROFITS 

Summary  of  Previous  Discussion.  We  have  already  observed 
that  profits  cannot  begin  until  all  costs  going  into  the  conversions 
from  which  the  profits  were  derived  have  been  provided  for,  and 
that  costs  include  not  only  the  obvious  cash  outlay  for  current 
expenses  but  commonly  outlay  of  other  things  than  cash;  that 
care  must  be  taken  not  only  that  all  outlay  properly  belonging  to 
the  period  in  question  be  included  in  the  cost  of  product,  but  that 
outlay  which  produces  its  effect  beyond  the  current  period  be  not 
counted  as  a  cost  wholly  of  the  current  period;  and  that  income 
also  may  need  analysis  to  see  whether  more  or  less  than  the  ap- 
parent income  of  the  period  is  actually  properly  creditable  to  that 
period. 

Confusion  of  Cost  with  Disposition  of  Profits.  The  first  need  of 
proper  accounting  for  profits  is  a  realization  that  disposition  of 
profits  may  easily  be  confused  with  costs,  and  that  one  of  the  two 
most  important  things  in  accounting  is  the  correct  statement  of 
profits  and  their  disposition.  Let  us  take  a  simple  illustration. 
Suppose  a  business  has  been  for  twelve  years  providing  what  it 
has  deemed  adequate  depreciation  for  its  machinery  but  now  finds 
that  the  machinery  is  obsolete  and  must  be  replaced.  Suppose 
the  allowance  for  depreciation  was  on  a  fifteen-year  basis,  and  the 
original  cost  of  the  machinery  was  $180,000.  Then  the  actual 
annual  charge  for  depreciation  was  $12,000  ($180,000  cost  ■*-  15), 
but  now  we  find  it  should  have  been  $15,000  ($180,000 -f-  12). 
Suppose  also  that  the  profits  of  this  year  on  the  strength  of  a 
$12,000  charge  for  depreciation  would  have  been  $50,000;  but  now 
:hat  we  see  that  the  annual  charge  for  depreciation  should  be 
$15,000,  we  take  the  actual  profits  at  $47,000  ($3,000  less  than 
before) .  Is  this  correct?  What  of  the  eleven  years  past  when  we 
charged  depreciation  only  $12,000  annually  but  should  have 
charged  $15,000?  Supposing  we  have  accumulated  no  surplus 
but  have  distributed  all  reported  earnings  as  dividends,  must  not 
this  $33,000  of  neglected  depreciation  be  charged  to  this  year?    If 


330  THE  FUNDAMENTALS  OF  ACCOUNTING 

so,  the  profits  of  the  year  are  reduced  to  $14,000  (the  previously 
given  $47,000  less  $33,000  correction  for  neglected  depreciation). 
This  would  give  an  absolutely  false  statement.  The  neglect  of 
adequate  depreciation  in  past  years  has  nothing  to  do  with  the 
profits  of  this  year:  only  the  proper  depreciation  of  this  year  can 
affect  this  year's  profits  —  which  are  $47,000.  Yet  if  there  is  no 
surplus  out  of  which  to  take  the  $33,000  neglected  depreciation 
of  the  past,  must  it  not  come  out  of  this  year's  profits?  Not  in 
the  sense  of  reducing  those  profits,  for  their  reaHty  is  unaffected  by 
that  neglected  depreciation;  but  the  disposition  of  that  $47,000 
may  be  much  affected  by  the  neglected  depreciation.  Unless 
the  company  has  more  working  capital  than  it  needs,  or  is  willing 
and  able  to  borrow  (thus  conducting  business  more  largely  than 
heretofore  with  other  people's  money),  it  must  withhold  a  part  of 
the  profits  from  distribution  as  dividends  and  apply  them  to  re- 
placing its  depleted  capital  —  and  we  know  that  the  capital  has 
been  depleted,  for  all  previous  supposed  profits  have  been  dis- 
tributed (else  there  would  now  be  a  surplus),  and  a  part  of  those 
supposed  profits  were  not  profits  but  capital.  If  the  company 
decides  to  withhold  the  $33,000  from  dividends,  it  will  show  the 
$47,000  on  the  income  sheet  as  profit  of  the  year,  and  then  show 
the  application  of  $33,000  of  it  to  the  correction  of  errors  of  past 
years.  If  it  decides  to  distribute  the  profits  of  the  year  in  spite 
of  the  error  of  former  years,  it  must  now  show  a  deficit  —  due  to 
the  disappearance  of  assets,  or  to  the  payment  of  dividends  in  past 
years  in  excess  of  earnings. 

Account  for  Disposition  of  Profits.  The  illustration  of  the 
preceding  paragraph  suggests  the  desirability  of  establishing 
a  clearing  account  particularly  for  the  disposition  of  profits. 
We  have  already  seen  that  a  clearing  account.  Net  Income,  may 
well  gather  together  all  sources  of  income,  from  different  fields  of 
activity,  and  set  off  against  them  the  results  in  fields  that  pro- 
duced loss,  so  that  the  balance  of  this  accoimt  shall  show  final 
net  income  from  all  sources.  This  may  well  be  closed  to  Disposi- 
tion of  Income.  This  method  is  preferable  to  showing  distribu- 
tions directly  on  Net  Income;  for  in  the  latter  case  the  debits  to 
Net  Income  may  include  both  losses  from  certain  activities  and 
disposition  of  profits,  and  it  is  desirable  to  run  no  risk  of  confu- 


THE  DISPOSITION  OF  PROFITS  33 1 

sion  between  them.  In  our  illustration  of  the  preceding  para- 
graph, Disposition  of  Income  would  be  credited  for  $47,000  from 
Net  Income,  and  would  be  debited  for  $33,000  for  the  depreciation 
previously  neglected.  The  complementary  credit  for  this  $33,- 
000  would  be  Machinery,  or  Allowance  for  Depreciation  of  Ma- 
chinery. Then  all  the  facts  of  the  case  will  appear  on  the  books 
and  will  be  available  for  the  statements.  If,  on  the  other  hand, 
the  company  decides  to  distribute  the  profits  of  the  year  in  spite  of 
the  deficit  of  past  years  just  discovered,  it  will  debit  Disposition 
of  Income  for  the  dividend  declared  and  credit  Dividends  De- 
clared; but  it  must  also  debit  Deficit  and  credit  either  Machinery 
or  Allowance  for  Depreciation  of  Machinery. 

Numerous  Applications  of  Profits.  That  the  applications  to 
which  profits  may  be  put  are  numerous  has  already  been  suggested 
by  the  various  accounts  discussed  in  the  last  part  of  the  chapter 
on  the  peculiarities  of  corporation  accounts.  These  we  directly 
observed:  Dividends,  Undivided  Profits,  Surplus,  and  Special 
Surpluses.  It  is  obvious,  moreover,  that  profits  may  be  applied 
not  only  to  accumulation  for  the  future  but  to  offsetting  deficits 
of  the  past,  as  just  discussed  in  the  preceding  two  paragraphs. 
Sometimes  those  deficits  are  newly  discovered  and  so  are  not  on 
the  books,  as  we  have  seen,  and  sometimes  they  may  have  stood 
long  on  the  books  awaiting  final  disposition.  Of  such  possible 
deficits  we  have  already  seen  Discount  on  Stock  Issued,  Operating 
Deficit,  Capital  Losses.  We  have  also  observed  that  theoretically 
income  taxes  are  a  division  of  profits  with  the  government,  and 
may  be  treated  as  disposition  of  income,  though  in  the  point  of 
view  of  the  individual  enterprise  they  are  costs  and  may  be 
deducted  from  earnings  before  profits  are  found.  Of  most  of 
these  dispositions  of  income  little  is  to  be  said,  for  they  are  ob- 
vious enough.  They  constitute  merely  either  subdivisions  of 
proprietorship  profit  or  application  of  current  profit  to  offset  pre- 
vious deficits;  and  it  should  be  clear  that  a  deficit  is  merely  the 
statement  of  the  excess  of  capital  stock  (or  partners'  credit)  above 
the  net  assets.  Only  a  deficit  in  excess  of  the  sum  of  capital 
stock  and  surplus  (for  there  may  be  an  operating  deficit  coin- 
ddently  with  a  capital  surplus  if  the  company  does  not  wish  to 
apply  that  surplus  to  that  deficit)  indicates  insolvency  —  though 


332  THE  FUNDAMENTALS  OF  ACCOUNTING 

insolvency  may  actually  occur  when  there  is  a  net  surplus,  for 
assets  may  prove  too  hard  to  convert  into  funds  acceptable  for 
paying  debt.  Special  surpluses,  however,  are  so  numerous  and  so 
varied,  and  occur  under  titles  so  little  explanatory,  that  some  of 
them  need  examination. 

Reserves.  Much  confusion  has  arisen,  in  interpreting  accounts, 
through  the  lack  of  any  established  practice  with  regard  to  pro- 
vision for  estimated  present,  as  contrasted  with  possible  future, 
losses  and  costs.  In  Chapter  VIII  we  discussed  Allowance  for 
Depreciation,  Allowance  for  Bad  Debts,  and  Allowance  for  Dis- 
counts Offered,  and  suggested  that  such  accounts  are  also  called 
"Reserve  for  Depreciation,"  etc.  It  was  pointed  out  then  that 
the  allowance  represents  the  best  estimate  that  can  be  made  of 
the  ''hole"  in  the  corresponding  asset;  but  the  measure  of  the 
hole  is  kept  in  a  separate  account,  rather  than  deducted  from 
the  asset  account,  for  statistical  purposes.  The  measure  of  the 
overstatement  of  the  asset  is  real,  therefore,  and  is  taken  into 
consideration  in  determining  profit  and  loss.  The  only  element 
of  uncertainty  is  the  amount  of  the  necessary  allowance;  and  this 
is  uncertain  only  because  though  the  transaction  involving  the 
cost  has  already  occurred,  the  result  of  it  cannot  be  known  until 
later  when  the  property  is  worn  out,  or  the  debt  becomes  due,  or 
the  discount  day  comes  around.  Entirely  different,  however,  is 
another  kind  of  provision  for  the  future.  Besides  costs  that  are 
normal  and  virtually  inevitable,  and  that  can  be  estimated,  are 
losses  which  are  extraordinary,  subject  to  no  regular  recurrence, 
escaped  altogether  by  many  businesses  and  by  many  others  for  a 
generation  or  two  at  a  time,  and  therefore  without  basis  for 
calculation.  The  Allowance  for  Depreciation,  Allowance  for 
Bad  Debts,  etc.,  are  intended  to  take  care  of  normal,  average, 
costs  of  this  sort,  on  the  principles  of  the  law  of  chance;  but  such 
things  as  obsolescence,  losses  by  bankruptcy,  etc.,  though  they 
fall  on  all  businesses  at  an  average  rate  (for  that  is  just  what  we 
mean  by  average),  as  a  matter  of  fact  fall  by  mere  chance  more 
heavily  on  some  than  on  others.  Yet  if  they  befall  a  business 
abnormally  it  may  be  put  to  its  downfall  unless  it  has  specially 
prepared  itself  to  endure.  Provision  should  be  made,  not  as  a 
matter  of  accounting  but  as  a  matter  of  policy,  for  such  occur- 


THE  DISPOSITION  OF  PROFITS  333 

rences.  Accounting  does  not  need  to  provide  for  them,  for  pro- 
vision has  already  been  made  for  the  normal,  the  calculable  costs 
of  business.  Policy,  however,  requires  that  out  of  profits  be  re- 
served from  distribution  as  dividend  something  for  this  purpose  — 
that  is,  a  part  of  the  assets,  originating  in  profits  which  might 
have  been  distributed  as  dividends,  be  kept  in  the  business  ready 
to  replace  any  assets  lost  through  one  of  the  mischances  of  bear- 
ing more  than  normal,  or  average,  losses.  Since  there  is  danger 
that  profits  so  retained  be  by  inadvertence  later  distributed,  thur 
abandoning  the  provision  for  bearing  extraordinary  losses,  it  is 
desirable  to  transfer  the  amount  of  such  reservation  from  Un- 
divided Profits  or  Surplus  to  a  special  surplus  account  with  a 
title  to  indicate  its  purpose,  as  Reserve  for  Extraordinary  De- 
preciation, Reserve  for  Extraordinary  Losses  from  Bad  Debts, 
Reserve  for  Fire  Hazard,  etc.,  as  described  on  page  266.  These 
titles  may  be  said  to  put  a  red  flag  on  certain  profits,  with  the 
implication  ''Hands  Off  —  For  Emergency  Only."  Unfortu- 
nately, however,  the  term  "reserve"  is  so  often  in  practice  used 
for  what  we  have  above  called  an  "  allowance,"  that  one  cannot  in 
trying  to  interpret  a  balance  sheet  always  know  which  is  found 
unless  one  can  find  an  interpreter.  The  practice  seems  to  be 
growing,  however,  of  applying  the  term  ''allowance"  to  a  hole  in 
the  assets,  and  the  term  "reserve"  to  profits  reserved  as  a  safety 
provision. 

Sinking  Funds.  One  type  of  reserve  has  led  to  much  curious 
confusion.  It  has  not  been  uncommon  for  corporations  to  pledge 
themselves  on  the  issue  of  bonds  to  establish  a  sinking  fund  that 
shall  provide  the  means  of  paying  at  maturity  the  debt  repre- 
sented by  the  bonds.  Commonly  the  sinking-fund  provision 
requires  that  the  sinking  fund  be  accumulated  out  of  income. 
A  sinking  fund,  moreover,  accumulates  through  the  addition  to 
it  of  interest  earned  on  the  investment  already  made  in  the  fund. 
A  part  of  the  progression  of  such  a  fund  estabKshed  out  of 
income  is  therefore  as  follows:  (i)  Disposition  of  Income  is 
debited  and  Reserve  for  Sinking  Fund  is  credited  —  thus  labeling 
the  profits,  so  to  speak;  (2)  Bonds  in  Sinking  Fund  (or  whatever 
account  represents  the  form  which  the  investment  of  the  fund 
happens  to  take)  is  debited  and  Cash  is  credited;  (3)  Bonds  in 


334  THE  FUNDAMENTALS  OF  ACCOUNTING 

Sinking  Fund  (or  its  substitute)  is  debited,  and  Reserve  for  Sink- 
ing Fund  is  credited  —  for  the  earnings  of  the  fund  and  invest- 
ment of  them;  (4)  these  processes  continue  until  time  for  payment 
or  until  the  fund  is  sufficient  for  its  purpose;  (5)  Bonds  Issued  is 
debited,  and  Bonds  in  Sinking  Fund  is  credited  —  to  cover  the 
application  of  the  fund  to  the  payment  of  the  debt  for  which  it  was 
accumulated;  (6)  the  net  result  of  this  is  that  Bonds  in  Sinking 
Fund  and  Bonds  Issued  are  closed,  but  the  Reserve  for  Sinking 
Fund  remains.  Here  is  where  the  confusion  arises.  We  have 
built  up  a  sinking  fund,  have  used  it  for  paying  debt,  and  yet  our 
fund  appears  to  persist.  In  order  to  observe  this,  let  us  set  up 
skeleton-ledger  accounts,  labeUng  the  entries  by  numbers  corre- 
sponding to  those  given  above,  adding  at  the  start  items  for  the 
property  purchased  with  the  proceeds  of  the  bonds  and  for  Bonds 
Issued  (a),  and  for  Disposition  of  Income  (only  so  much  of  the 
income  as  will  be  apphed  to  this  use)  and  for  Cash  (b),  using  sup- 
posititious figures,  and  supposing  one  round  of  the  cycle  will 
sufficiently  build  up  our  fund. 

Property  Bonds  Issued 

(a)  210,000  (s)  210,000  (a)  210,000 

Disposition  of  Income  Cash 

(i)  200,000  (b)  200,000  (b)  200,000  (2)  200,000 

Reserve  for  Sinking  Fund  Bonds  in  Sinking  Fund 

(i)  200,000  (2)  200,000  (5)  210,000 

(3)    10,000  (3)    10,000 


210,000  210,000 


We  end  with  a  debit  to  Property  and  a  credit  to  Reserve  for 
Sinking  Fund. 

Reserve  for  Sinking  Fund.  What  is  the  nature  of  this  reserve 
for  sinking  fund?  It  was  established  as  a  reservation  of  profits 
against  distribution  of  dividend;  and  of  course  when  we  reserve 
the  profits  we  equally  reserve  from  distribution  the  assets  which 
constitute  those  profits  —  for  the  assets  and  the  profits  are  two 
aspects  of  the  same  thing.  Yet  the  assets  seem  to  have  disap- 
peared but  the  profits  seem  to  remain.  If  we  were  to  take  a 
balance  sheet  of  the  accounts  shown  above  as  they  looked  before 


THE  DISPOSITION  OF  PROFITS  335 

the  earning  of  the  profits  which  estabKshed  the  sinking  fund,  and 
then  again  as  they  look  after  the  fund  has  served  its  purpose,  we 
get  an  interesting  contrast. 

Balance  Sheet  Before  Profits  Earned 
Property  $210,000      Bonds  Issued  $210,000 

Balance  Sheet  After  Sinking  Fund  Used 
Property  $210,000      Reserve  for  Sinking  Fund  $210,000 

What  was  the  source  of  the  property  under  the  first  balance  sheet? 
Clearly  a  loan.  Under  the  second?  Clearly  the  reserve.  How 
can  we  have  eaten  our  cake  and  yet  still  have  it?  How  can  we 
have  used  the  fund  to  pay  our  debt  and  still  have  the  fund?  The 
answer  to  these  questions  involves  two  fundamental  business 
principles:  we  cannot  use  profit  or  reserve  to  pay  debt,  but  we  can 
pay  debt  by  using  the  assets  which  are  the  complements  of  the 
profit  or  reserve;  and  we  are  never  made  poorer  by  paying  debt, 
but  have  the  same  profit,  reserve,  surplus,  after  paying  debt  as 
before.  The  payment  of  debt,  though  it  reduces  assets,  reduces 
liabilities;  and  so  the  net  worth,  or  proprietorship,  is  unchanged 
by  the  process.  If  we  had  a  reserve  before,  we  have  it  now;  but 
though  we  had  the  assets  of  the  fund  before,  we  have  them  no 
longer  —  at  least  in  positive  form;  we  still  have  them  in  negative 
form,  however,  for  we  have  got  rid  of  a  debt.  Our  reserve  was 
previously  in  the  form  of  assets:  it  is  now  in  the  form  of  immunity 
from  debt:  and  as  one  form  is  as  good  as  the  other,  the  reserve  is  as 
real  as  ever.  What  now  shall  we  do  with  it?  It  is  ridiculous  to 
call  it  a  "reserve  for  sinking  fund"  when  we  no  longer  have  need 
for  a  sinking  fund.  We  temporarily  labeled  it  in  such  fashion 
as  would  show  that  we  were  complying  with  the  terms  of  the 
sinking  fund,  and  would  force  us  to  reserve  sufficient  profits  for  the 
purpose.  The  purpose  has  been  served :  the  cash  has  been  applied 
to  the  payment  of  debt  and  we  are  no  longer  in  danger  of  using 
it  for  dividends :  we  may  now  take  off  the  red  flag  of  caution.  We 
do  this  by  debiting  Reserve  for  Sinking  Fund  and  crediting  Sur- 
plus (providing  we  do  not  care  to  carry  it  to  a  special  surplus) . 
When  this  has  been  done,  our  balance  sheet  shows,  as  contrasted 
with  the  original  balance  sheet  before  the  profits  were  earned, 
that  whereas  originally  we  held  the  property  as,  so  to  speak,  bor- 


336  THE  FUNDAMENTALS  OF  ACCOUNTING 

rowed,  we  now  hold  it  as  earned.  The  surplus  account  now  shows 
its  final  standing,  as  the  bond  account  showed  its  original  stand- 
ing. 

Summary.  The  substance  of  disposition  of  income  may  well  be 
expressed  in  the  form  of  a  few  skeleton-ledger  accounts  showing 
the  source  and  disposition  of  profits  in  a  supposititious  case. 

Net  Income 

Steamship  Line                             17,000        Trading  268,000 

Commissary  Department             21,000        Interest  Earned  18,000 

Disposition  of  Income                334,ooo        Rental  Earned  22,000 

Commission  Earned  64,000 


372,000 

372,000 

Disposition  op  Income 

Reserve  for  Sinking  Fund 

16,000       Net  Income 

334»ooo 

Reserve  for  Extraordinary  De- 

preciation of  Plant 

8,000 

Reserve     for     Extraordinary 

Losses 

17,000 

Subscription    to    Employees' 

Pension  Fund 

25,000 

Dividends 

180,000 

Surplus              '-^ 

80,000 

Undivided  Profits 

8,000 
334,000 

334,000 

Surplus 

Allowance  for  Depreciation  of 

Balance 

283,000 

Plant 

18,000        Allowance  for  Bad  Debts 

8,000 

Fire  Loss 

12,000       Disposition  of  Income 

80,000 

Appropriation  for  Research 

16,000 

Balance 

325,000 
371,000 

371,000 

Balance  325,000 

The  other  accounts  involved  need  not  be  shown.  Only  a  few 
items  here  need  special  comment.  The  first  two  items  on  the 
debit  side  of  Net  Income  represent  losses  of  particular  activities, 
and  the  third  is  the  balance  of  net  income.  The  fourth  debit  to 
Disposition  of  Income  represents  a  gift  out  of  profits  to  the  pen- 
sion fund  for  employees.  The  subscription  account  was  credited 
as  a  liability  when  this  entry  was  made,  and  will  be  debited  when 
payments  are  made.  The  first  debit  to  Surplus  is  to  correct  in- 
sufficient allowance  for  depreciation  in  previous  years,  and  hence 


THE  DISPOSITION  OF  PROFITS  337 

is  not  charged  either  against  this  year's  operations  or  against 
Reserve  for  Extraordinary  Depreciation.  The  next  debit  is  for  a 
fire  loss  in  excess  of  the  provision  for  fire  loss.  The  next  debit  is 
for  an  appropriation  out  of  accumulated  profits  for  scientific  re- 
search. The  appropriation  account  was  credited  when  this  entry 
was  made,  and  will  be  debited  when  expenditures  are  made.  The 
first  credit  to  Surplus,  other  than  the  balance,  is  for  a  correction  of 
the  allowance  for  bad  debts  made  in  an  earlier  period  but  now 
found  unnecessary.  The  next  item  is  for  the  portion  of  net  in 
come  transferred  to  Surplus  through  Disposition  of  Income. 

QUESTIONS  AND  PROBLEMS 

1.  A  business  receives  an  award  of  $100,000  and  costs  on  a  suit  which 
has  been  pending  for  three  years,  (a)  To  what  account  should  the 
receipt  of  the  money  for  the  costs  of  the  suit  be  credited?  (b)  Is  the 
$100,000  award  a  profit?  (c)  How  should  the  $100,000  be  treated  on 
the  books? 

2.  A  business  manufactured  a  year  ago  on  contract  goods  which  were  re- 
jected and  thought  unsalable  because  of  a  flaw.  They  were  reduced  on 
the  books  from  cost  ($40,000)  to  scrap  value  ($1 ,000) .  This  year  owing 
to  changed  conditions  the  goods  became  salable  and  were  sold  for 
$20,000.  What  entry  should  be  made  for  the  sale,  if  (a)  the  loss  a  year 
ago  was  treated  as  a  loss  for  the  year,  (b)  it  was  not  so  treated? 

3.  What  features  of  each  of  the  following  distinguish  it  from  each  of  the 
others?  An  allowance,  a  reserve  (as  the  term  is  used  in  this  book),  a 
provision,  a  reserve  fund. 

4.  The  tentative  balance  sheet  of  a  corporation,  which  has  distributed  all 
its  net  income  as  dividends,  but  has  retained  $10,000  of  gross  income 
to  cover  depreciation  estimated  at  that  amount,  awaiting  a  decision  of 
the  directors  as  to  the  treatment  of  depredation  upon  the  books,  is 
shown  below: 

$120,000 

10,000 
S,ooo 


Real  Estate 

$100,000 

Capital  Stock 

Cash 

20,000 

Gross  Income  (available  to 

Other  Assets 

15,000 

cover  depredation) 
Surplus 

$135,000  $135,000 

Show  how  the  balance  sheet  would  look  under  each  of  the  following 
polides: 

(a)  Writing  down  the  property,  and 

(i)  Setting  aside  a  fimd  in  cash  to  cover  depredation. 
(2)  Not  setting  aside  a  fund. 

(b)  Setting  up  an  allowance  of  $10,000,  and  creating  a  reserve  of 
$4iOoo  for  future  extraordinary  depredation. 


338  THE  FUNDAMENTALS  OF  ACCOUNTING 

5.  The  trial  balance  of  a  corporation,  with  certain  additional  information, 
is  given  below.  Construct  from  the  figures  the  accounts  for  merchan- 
dise, trading,  net  income,  disposition  of  profits,  and  surplus;  and  show 
the  balance  sheet. 


Trial  Balance 

Capital  Stock 

150,000 

Plant 

141,350 

Notes  Receivable 

76,800 

Accounts  Receivable 

4S,ooo 

Cash 

28,130 

Notes  Payable 

75,000 

Accounts  Payable 

12,500 

Sales 

160,500 

Wages  and  Salaries 

49,184 

Purchases 

7S,8i6 

Discounts  Given 

880 

Commission  Earned 

5.000 

Selling  Expense 

10,000 

Taxes 

620 

Insurance 

310 

Interest 

820 

Office  Supplies 

360 

Maintenance 

2,220 

Surplus 

37,500 

Fire  Loss 

9,010 
440,500 

'^ 

440,500 

Wear  and  tear  for  the  year  is  estimated  at  $2,500;  the  merchandise 
on  hand  cost  $25,000,  but  has  a  present  market  value  of  $20,000;  debt 
loss  estimated  is  $2,000;  a  provision  for  fire  loss  of  $1,500  is  made;  divi- 
dends of  7%  are  declared;  $11,500  is  reserved  for  income  taxes;  $12,000 
of  income  is  carried  to  surplus;  $2,000  is  reserved  for  depreciation;  cash 
is  set  aside  in  a  special  fimd  to  cover  the  reserve  for  depreciation;  it  is 
decided  not  to  charge  to  the  year  the  fire  loss  now  on  the  books. 


CHAPTER  XX 

THE  INTERPRETATION  OF  FINANCIAL  STATEMENTS 

Uncertain  Standards  of  Measurement.  We  have  already  several 
times  observed  the  lack  of  uniformity  of  method  in  accounts. 
This  is  due  not  only  to  differences  of  accounting  policy,  but  to 
differences  of  judgment  about  values.  Much  accounting  is  more 
a  matter  of  judgment  than  of  application  of  predetermined  fixed 
standards.  For  instance,  the  choice  of  a  basis  of  capitalization 
is  a  matter  of  accounting  poKcy,  and  might  be  fixed  by  custom  or 
by  law;  but  even  if  that  were  fixed  and  universally  adopted, 
differences  of  judgment  regarding  rates  of  depreciation,  allow- 
ances for  bad  debts,  etc.,  would  remain,  and  accounts  would  re- 
flect those  differences.  In  any  case,  then,  one  must  interpret 
accounts  with  knowledge  not  only  of  the  policy  but  of  the  sort  of 
judgment  that  is  behind  them.  When  these  things  cannot  be 
learned,  one  takes  the  accounts  with  "  a  grain  of  salt,"  for  safety's 
sake.  Theoretically,  a  balance  sheet  is,  as  we  have  seen,  a  state- 
ment of  assets  and  HabiUties  —  provided  we  take  proprietorship 
as  a  liabihty  of  the  business  to  its  owners;  but  an  asset  for  the 
purpose  of  paying  debts  through  the  liquidation  process  is  very 
different  from  an  asset  for  the  purpose  of  conducting  a  going 
business,  and  each  of  these  may  be  very  different  from  an  asset  as 
a  means  of  explaining  what  has  become  of  an  owner's  investment. 
What  we  can  most  profitably  use  is  usually  information  regarding 
the  convertible  value  of  the  current  assets,  the  current  liabilities, 
the  cost  of  the  fixed  assets,  and  the  long-term  Habilities:  we  wish 
to  compare  the  convertible  value  of  current  assets  with  current 
liabiHties,  in  order  to  see  the  probability  of  pa)anent  at  maturity; 
and  we  wish  to  compare  the  cost  of  fixed  assets  with  the  long- 
time Habilities,  for  we  wish  to  see  how  much  of  the  investment  in 
fixed  property  has  been  borrowed  and  how  much  is  invested  by 
the  proprietors  out  of  their  own  funds.  If  the  balance  sheet  has 
not  been  constructed  on  this  plan,  interpretation  of  it  should 
adjust  for  these  elements,  so  that  in  the  end  a  statement  of  assets 
and  liabilities  can  be  drawn  up  —  either  formally  or  by  mental 
adjustment  in  reading  the  balance  sheet.  In  general,  the  ac- 
counting methods  defended  in  the  preceding  chapters  provide  for 
such  adjustments  —  current  assets  for  sale  taken  at  cost  or  mar- 


340  THE  FUNDAMENTALS  OF  ACCOUNTING 

ket,  whichever  is  lower,  current  assets  for  collection  taken  at 
estimated  collectibility,  and  agents  of  production  (both  fixed 
assets,  and  materials  for  production  and  service)  taken  at  cost. 
When  this  is  done  we  preserve  all  the  information  that  the  business 
needs  for  historical  record,  and  have  a  definite  point  of  departure 
for  making  allowances  and  adjustments  in  converting  the  balance 
sheet  into  a  statement  of  realizable  assets  and  payable  liabilities 
as  a  test  of  either  ultimate  or  immediate  solvency. 

Ultimate  and  Immediate  Solvency.  Many  a  business  has  gone 
through  insolvency  and  yet  paid  "one  hundred  cents  on  the  dol- 
lar" without  new  earnings.  It  was  insolvent  immediately  but 
not  insolvent  ultimately.  Its  assets  were  as  great  as  its  liabili- 
ties, but  its  assets  were  not  convertible  into  cash  as  fast  as  the 
liabilities  demanded  cash.  Accounts  receivable  amounting  to  one 
hundred  thousand  dollars  if  collectible  in  two  months  will  not 
pay  accounts  payable  of  ten  thousand  dollars  if  due  in  one  month 
—  unless  they  can  be  used  as  security  for  borrowing.  So  a  balance 
sheet  is  not  a  wholly  satisfactory  statement  of  solvency  even  when 
all  figures  are  adjusted  to  actual  collectibility.  The  element  of 
time  must  be  added.  In  other  words,  a  balance  sheet  at  best  can 
serve  only  as  a  basis  for  a  statement  of  assets  and  liabilities,  and 
to  try  to  make  it  do  anything  else  is  largely  to  spoil  its  value  for 
what  it  might  do  wholly  well. 

A  Statement  of  Assets  and  Liabilities.  For  purposes  of  show- 
ing solvency  the  best  form  of  statement  is  based  upon  the  balance 
sheet  and  shows  on  its  face  that  it  is  not  inconsistent  with  that 
sheet.  No  standard  form  is  available,  for  no  two  businesses  and 
no  two  times  in  the  same  business  would  require  the  same  form. 
Let  us  from  the  balance  sheet  shown  below,  for  example,  construct 
a  supposititious  statement  of  assets  and  liabiHties. 


Balance 

'■  Sheet 

Cash 

$    7,000 

Notes  Payable                          $  20,000 

Accounts  Receivable 

128,000 

Mortgage  Notes  Payable             15,000 

Merchandise 

116,000 

Accounts  Payable                       140,000 

Furniture  &  Fixtures 

2,500 

Accrued  Liabilities                       17,000 

Real  Estate 

25,000 

Allowance  for  Depreciation  of 

Allowance  for  Discounts  Avail- 

Real Estate                                4,000 

able 

4,000 

Allowance  for  Bad  Debts              2,500 
Allowance  for  Discounts  Offered     3,000 
John  Doe  (Permanent  Loan)      30,000 
Proprietor                                    5^,000 

$282,500 

$282,500 

INTERPRETATION  OF  FINANCIAL  STATEMENTS      341 

The  first  step  in  showing  assets  and  liabilities  in  such  form  that 
judgment  of  solvency  is  easy  is  to  analyze  those  items  that  are  not 
all  of  a  sort  —  that  is,  separate  into  classes  those  that  are  not  all 
applicable  to  the  same  thing  at  the  same  time.  This  means  re- 
constructing our  balance  sheet  as  a  whole  so  that  in  the  proof  of 
debits  and  credits  we  may  be  sure  that  we  have  not  lost  track  of 
anything.  We  must  show,  for  example,  that  our  accounts  re- 
ceivable consist  not  only  of  sums  collectible  at  different  times,  but 
of  sums  not  collectible  at  all  and  shown  as  contra  items  on  the 
balance  sheet.  Yet,  for  the  sake  of  showing  both  the  real  value 
and  the  book  figures,  we  show  the  contra  items  on  both  sides  of 
our  statement  (thus  in  a  sense  padding  both  sides  together) 
rather  than  subtract  contra  items.  The  analyzed  balance  sheet 
follows. 

Analyzed  Balance  Sheet 
I7.000 


Cash 

Accounts  Receivable 
Estimated  collections  in 
first  month 
second  month 
third  month 
later 
Estimated  discounts  (contra) 
Estimated  losses  (contra) 
Itierchandise 
Estimated  converted  by 
cash  sales  in 
first  month 
second  month 
third  month 
Estimated  converted  by 
charge  sales  in 
second  month 
third  month 
later 
Furniture  and  Fixtures 
Real  Estate 
Applicable  on  Mortgage 

Notes  Payable  (contra) 
Allowance  for  Depreciation 

(contra) 
Balance,  equity 
Allowance  Disct.  Available 
(contra) 


167,000 

4S.OOO 

8,000 

3,000 
2,500 


$40,000 
20,000 
10,000 


15,000 
iS,ooo 

16,000 


|z5,ooo 

4,000 
6,000 


128,000 


Notes  Payable 
Due  in 
first  month 
second  month 
Mortgage  Notes  Payable 

(contra) 
Accounts  Payable 
Due  in 
first  month 
second  month 
third  month 
Discounts  available  (contra) 
Accrued  liabilities 

Due  in  first  month 
Allowance  Depreciation  R.  E. 

(contra) 
Allowance  Bad  Debts 

(contra) 
Allowance  Discounts  Offered 
(contra) 
2,500    John  Doe 
Proprietor 


$  S.ooo 
15.000    120,000 

15,000 

$70,000 
40,000 
26,000 
4,000  140,000 


116,000 


25,000 


1282,500 


17,000 

4.000 

2,500 

3,000 
30,000 
SXiOOO 


$282,500 


We  have  next  to  relate  the  various  items  of  assets  and  Kabilities 
to  each  other  in  such  a  way  that  we  may  see  how  far  the  former 
will  take  care  of  the  latter  —  on  the  supposition  that  the  business 
continues  and  proceeds  to  convert  the  naturally  convertible 
assets,  but  without  taking  into  account  any  new  business  (or 
profits)  other  than  naturally  liquidating  the  old.  The  sheet  fol- 
lowing does  not  show  the  estimated  status  of  the  business  in  the 


342 


THE  FUNDAMENTALS  OF  ACCOUNTING 


new  period,  for  that  would  be  entirely  outside  the  scope  of  this 
sort  of  statement;  it  shows  merely  how  the  present  assets  and 
liabilities  will  stand  with  respect  to  each  other  as  they  follow 
natural  progression;  and  thus  we  may  see  whether  the  assets  will 
automatically  take  care  of  the  liabilities  and  not  require  assist- 
ance from  the  new  period. 

Statement  of  Assets  and  Liabilities 


Assets 
Cash  $    7,000 

Accounts  Receivable,  estimated  collec- 
tions in  first  month  67,000 
Merchandise,  recent  average  cash  sales 
in  one  month                                              40,000 


Assets  available  in  first  month 


$114,000 


Liabilities 
Notes  Payable  due  in  first  month  $    S,ooo 

Accounts  Payable  due  in  first  month  70,000 
Accrued  Liabilities  due  in  first  month  i7>ooo 
Liabilities  due  in  first  month  192,000 

Balance  of  assets  available  in  first 
month  22,000 

|ii4,ooo 


Balance  from  first  month 

Accounts  Receivable,  estimated  collec- 
tions in  second  month  from  present  Ac- 
counts Receivable 

Merchandise,  estimated  cash  sales  in 
second  month,  from  present  stock 

Merchandise,  estimated  collections  in 
second  month  from  charge  sales 
made  from  present  stock,  based  on 
average  payments  on  sales 

Assets  available  in  second  month 


Balance  from  secondmonth 

Accounts  Receivable,  estimated  collec- 
tions in  third  month 

Merchandise,  estimated  cash  sales  in 
third  month,  from  present  stock 

Merchandise,  estimated  collections  in 
third  month  from  charge  sales  made 
from  present  stock,  based  on  average 
payments  on  sales 

Assets  available  in  third  month 


Balance  of  third  month 
Balance  of  Accounts  Receivable 
Balance  of  Merchandise 
Furniture  and  Fixtures 
Real  Estate  $25,000 

Less  Depreciation  R.  E.  4,000 


Less  Mortgage  Notes  Pay- 
able 


$21,000 
iS.ooo 


$22,000 


4S.OOO 
30,000 


iS.ooo 
$102,000 

147,000 

8,000 

zo,ooo 


IS.ooo 

$80,000 


$S4.ooo 

2,SOO 

16,000 

2,500 


6,000 


$8i.c 


Notes  Payable,  due  in  second  month  $15,000 
Accounts  Payable,  due  in  second  month  40,000 
Liabilities  due  in  second  month  $SS,ooo 

Balance  of  assets  available  in  second 
month  47iOOO 


Accounts  Payable,  due  in  third  month 
Liabilities  due  in  third  month 
Balance  of  assets  available  in  third 
month 


John  Doe.  permanent  loan 
Proprietor 


$102,000 


$26,000 
$26,000 


54.000 


$80,000 

$30,000 
51,000 


$81,000 


We  here  have  a  prospectus  of  the  future  history  of  present  affairs, 
and  from  it  we  see  that  the  future  does  not  need  to  look  out  for 
anything  but  itself.  Indeed,  the  present  will  provide  certain 
resources  for  the  future.  The  first  month  will  convert  into  liquid 
form  $22,000  of  assets  more  than  will  be  needed  for  old  debts,  and 
as  the  second  and  the  third  month  each  more  than  takes  care  of 
itself,  it  is  obvious  that  the  excess  of  liquid  assets  of  each  month 


INTERPRETATION  OF  FINANCIAL  STATEMENTS      343 

may  go  back  into  the  business  for  replenishing  stock,  etc.  If  such 
a  statement  is  taken  monthly  the  manager  may  know  what  buy- 
ing, selling,  and  financial  policy  is  wisest  to  adopt,  and  creditors 
who  have  access  to  the  sheet  may  know  fairly  well  what  risks 
they  are  taking.  As  with  all  accounting  statements,  however,  the 
value  depends  upon  the  correctness  of  the  estimates;  for  all 
financial  statements  of  businesses  having  a  large  body  of  salable 
and  collectible  items  are  only  approximations  to  absolute  final 
values.  The  last  section  of  this  statement  does  not  attempt  to 
show  converted  values  except  in  the  case  of  the  mortgage  note, 
for  in  no  case  is  the  conversion  imperative.  This  section  shows 
that  the  long-term  creditors  are  protected,  and  shows  where  the 
proprietor's  investment  stands. 

Interpreting  Individual  Items  of  a  Balance  Sheet.  Most  of  the 
things  that  one  should  bear  in  mind  in  attempting  to  interpret  a 
balance  sheet  have  already  been  discussed  in  one  connection  or 
another,  such  as  the  need  of  realizing  that  accounts  receivable 
and  notes  receivable  will  not  often  prove  all  good,  that  allowance 
for  uncoUectibiHty  must  be  made,  and  that  the  size  of  the  allow- 
ance depends  on  many  things:  many  people  are  naturally  opti- 
mistic and  make  allowances  too  small;  but  many  businesses  have 
a  specially  unreHable  Hne  of  customers,  and  what  may  be  a  per- 
fectly good  allowance  for  bad  debts  in  one  business  may  be  wholly 
inadequate  in  another  business  in  the  same  Hne  of  trade  in  the 
same  town  at  the  same  time.  Anybody  can  sell  goods  if  he  is  not 
particular  whom  he  trusts.  When  it  comes,  moreover,  to  finding 
immediate  solvency,  we  have  seen  that  assets  good  for  a  continu- 
ing business  must  sometimes  be  sold  for  a  song  when  the  business 
is  liquidated.  One  can  learn  what  allowance  to  make  for  such 
things  from  experience  only.  They  are  not  matters  of  account- 
ing, but  of  judgment.  One  must  realize,  moreover,  that  values 
put  on  the  books  for  one  purpose  are  not  to  be  interpreted  as  for 
another. 

The  Form  of  Balance  Sheets.  No  standard  form  is  recognized 
except  in  a  few  businesses  either  under  government  control  or 
associated  with  other  businesses  of  the  same  type  to  maintain 
uniform  methods  of  accounting  (for  the  purpose  of  mutual  benefit 
through  comparison  of  operations) ;  and  the  forms  determined  as 


344  THE  FUNDAMENTALS  OF  ACCOUNTING 

standards  by  these  various  agencies  have  little  in  common.  In- 
deed, as  we  have  seen,  the  needs  of  different  businesses  are  so 
widely  variant  that  no  standard  form  is  generally  acceptable. 
Only  certain  general  principles  can  become  standard. 

Order  of  Assets  and  Liabilities.  It  used  to  be  common,  well- 
nigh  universal,  to  arrange  both  assets  and  HabiHties  in  order  of 
permanence  —  real  estate,  machinery,  etc.,  down  through  ac- 
counts receivable  and  merchandise  to  cash,  and  capital  stock 
down  to  claims  due  and  unpaid.  Then  the  taste  of  accountants 
swung  in  the  opposite  direction  and  led  to  Cash  as  the  first  asset 
and  Real  Estate  as  the  last.  This  is  purely  a  matter  of  taste  or 
emphasis.  In  the  balance  sheet  above,  on  page  340,  the  latter 
order  is  used,  because  we  are  putting  emphasis  on  the  balance  sheet 
as  a  statement  of  assets  and  liabilities  for  purposes  of  immediate 
solvency.  If,  however,  the  sheet  were  to  be  used  primarily  as  a 
statement  of  costs  and  ownership,  the  natural  order  would  be  the 
reverse. 

Classification  of  Assets  and  Liabilities.  Whatever  general 
order  for  items  is  adopted,  it  is  desirable  to  arrange  items  either 
in  groups  suggesting  permanence,  or  in  groups  suggesting  sol- 
vency.   A  convenient  grouping  to  suggest  permanence  follows: 

Property  Investment  Capital  Stock 

Bonded  Debt 
Working  Assets  Working  Liabilities 

Accrued  Assets  Accrued  Liabilities 

Prepaid  and  Deferred  Assets  Deferred  Liabilities 

Surpluses 
Contingent  Assets  Contingent  Liabilities 

Here  working  assets  include  assets  of  quickly  converted  type  but 
needed  to  keep  the  business  going,  like  Cash,  Merchandise,  Sup- 
plies, and  Accounts  Receivable.  A  different  grouping  more 
clearly  suggests  solvency: 

Current  Assets  Current  Liabilities 

Accrued  Assets  Accrued  Liabilities 

Prepaid  and  Deferred  Assets  Deferred  Liabilities 

Securities  Investment  Bonded  Debt 

Working  Investment  Capital  Stock 

Surpluses 

Contingent  Assets  Contingent  Liabilities 


INTERPRETATION  OF  FINANCIAL  STATEMENTS      34S 

Most  items  classified  as  "working"  in  the  first  grouping  would 
here  appear  as  "current."  Supplies,  however,  though  working 
assets,  are  hardly  current  assets  in  the  sense  that  they  are  availa- 
ble for  paying  debts,  for  the  sale  of  suppUes  for  raising  money 
would  often  necessitate  the  shutting  down  of  the  business.  Un- 
der this  classification,  therefore,  supplies  should  rather  be  in- 
cluded in  working  investment  along  with  plant  and  real  estate. 
Under  both  classifications  deferred  assets  and  liabiUties  would 
include  items  expected  to  be  deferred  over  a  considerable  period 
—  like  advances^  to  subsidiary  or  alHed  companies  and  funds 
accumulated  for  future  use. 

Growing  Informality  of  Balance  Sheets.  Of  late  years,  with 
greater  willingness  for  publicity,  many  business  houses  have  come 
to  present  balance  sheets  in  a  form  that  would  be  more  intelligible 
to  stockholders  than  the  mere  reproduction  of  ledger  items  in 
parallel-column  form,  like  a  closed  ledger  account.  This  has  led 
to  the  growing  habit  of  omitting  proprietorship  entirely  as  a  lia- 
bility of  the  business  (repudiating,  in  a  sense,  the  idea  of  the  busi- 
ness as  an  entity  liable  to  its  stockholders  for  the  care  of  their 
property)  and  carrying  it  as  a  residue  —  that  is,  showing  that 
what  assets  are  not  claimed  by  outsiders  are  the  property  of  the 
proprietors.  Such  a  balance  sheet  in  summary  form,  without 
subdivision  by  groups,  might  look  as  shown  below. 


Cash 

In  First  National 

Bank 

lio.ooo 

In  Columbia  Trust 

Co. 

S,ooo 

|iS,ooo 

Merchandise 
In  main  store 

Jai.ooo 

In  branch  store 

7,000 

28,000 

Accounts  Receivable  ^ 

130,000 

Less 

Allowance  for  Bad 

Debts 

Si. 000 

Allowance  for  Dis- 

counts 

2,000 

3.000 

27.000 

Accrued  Interest 

400 

Prepaid  Insurance 

Soo 

Employees'  Savings 

Fund« 

2,500 

Supplies 

1,200 

Furniture  &  Fixtures 

1,000 

Real  Estate 

I3S.000 

Less  Allowance  for 

Depreciation 

4,000 

31.000 

$106,600 

Accounts  Payable 

Less  Allowance  for  Dis- 
counts 
Accrued  Liabilities 
Employees'  Trust  Liability 
Provision  for  Fire  Hazard 


I33.000 

1,000  132,000 
3,000 

2,SOO 

2,000 


Balance  of  Stockholders'  Equity,  rep- 
resented by: 

Capital  Stock  $50,000 

Reserve  for  Depreciation       3,000 
Surplus  10,000 

Undivided  Profits  4,100 


l39,Soo 


67,100 


|io6,6oo 


>  Excluding  those  due  from  branch. 


I  In  Liberty  Bonds,  4^%,  bought  and  carried  at  par. 


346  THE  FUNDAMENTALS  OF  ACCOUNTING 

Special  Designation  of  Specific  Items.  The  items  must  not  be 
so  vague  as  to  serve  as  cover  for  misrepresentation.  Often  all 
sorts  of  odds  and  ends  of  debts  due  have  been  reported  as  cash 
items  —  such  as  bad  checks  still  held  in  the  cash  drawer,  I.O.U.'s, 
etc.  To  avoid  suspicion  of  this,  it  is  well  to  report  details  of  cash. 
Sometimes  branches  and  the  main  business  have  been  inter- 
twined; so  that  merchandise  was  counted  in  both  places,  and  the 
debt  due  the  main  house  by  the  b  anch  for  merchandise  was 
counted  as  an  account  receivable  to  the  main  house  but  was  not 
counted  as  an  account  payable  by  the  branch.  This  resulted  in 
counting  the  same  asset  twice.  To  show  that  this  has  not  hap- 
pened, it  is  well  to  designate  the  exact  plan  followed.  Trust  and 
other  funds  may  well  be  designated  not  only  as  funds,  but  in  a 
footnote  as  specific  investments.  Here  the  Liberty  Bonds  are 
shown  as  bought  and  carried  at  par;  and  hence  even  if  they  hap- 
pen not  to  be  worth  par  on  the  market  at  this  time  they  discharge 
the  Hability  for  the  trust  shown  on  the  opposite  side  of  the  balance 
sheet.  It  is  also  common  to  report  contingent  assets  and  liabili- 
ties in  a  footnote  rather  than  in  the  body  of  the  balance  sheet. 

Finding  Tendencies.  As  a  matter  of  fact,  a  single  balance 
sheet  is  not  nearly  so  serviceable  for  showing  the  condition  of  a 
company  as  two  —  in  spite  of  the  fact  that  the  earlier  one  may 
have  been  long  dead.  Tendencies  are  often  quite  as  important  as 
momentary  conditions,  and  often  an  important  tendency  will  be 
shown  by  a  comparison  of  two  balance  sheets.  The  easiest  way 
to  discover  tendencies  is  to  make  a  list  of  changes  between  two 
balance  sheets  and  then  observe  whether  the  changes  are  in  the 
right  direction.  A  decrease  in  cash,  for  instance,  is  a  bad  thing  if 
cash  is  sorely  needed,  but  it  is  a  good  thing  if  cash  is  lying  idle. 
An  increase  in  accounts  receivable  is  a  good  thing  if  it  is  due  to 
increasing  sales,  but  it  is  a  bad  thing  if  it  is  due  to  increasing  un- 
collectibility  of  bills.  Often  tables  of  changes  in  balance  sheets 
bring  out  prominently  facts  that  were  hardly  observable  from  the 
balance  sheets  themselves,  particularly  when  the  figures  are  stud- 
ied with  figures  from  the  operating  statement. 

Summary  of  Balance-Sheet  Changes.  It  is  obvious  that  a 
change  in  a  balance-sheet  figure  of  one  time  as  compared  with  that 
of  another  time  is  due  either  to  a  transaction  (or  series  of  transac- 


INTERPRETATION  OF  FINANCIAL  STATEMENTS       347 

tions)  iwhich  has  changed  the  asset  or  ownership-claim,  or  to  a 
mere  change  in  the  value  attached  to  the  item;  and  a  change 
merely  of  valuation  must  change  some  other  figure,  because  we 
are  dealing  in  double  entry.  So  every  change  between  one  bal- 
ance sheet  and  the  next  is  matched  by  another  change,  and  there- 
fore our  summary  of  changes  must  itself  balance  —  or  consist  of 
two  equal  parts.  It  is  next  obvious  that  transactions  which  offset 
each  other  will  not  appear  on  a  summary  of  changes,  for  the  net 
effect  on  the  balance  sheet  is  nothing  at  all.  Let  us  see  just  what 
that  means  in  practice.  Suppose  $100,000  is  collected  in  cash  in 
the  new  year  on  old  accounts  receivable,  and  new  sales  of  $100,000 
are  still  unpaid  and  therefore  appear  as  accounts  receivable;  these 
transactions  will  produce  no  effect  on  Accounts  Receivable,  for 
the  disappearance  of  an  old  $100,000  cancels  the  creation  of  a 
new.  If,  again,  the  $100,000  received  on  the  old  collections  goes 
to  buy  merchandise  and  pay  expenses  involved  in  the  sale  of  the 
new  $100,000,  and  these  cost  $100,000,  no  change  in  cash  appears 
in  comparison  of  the  two  balance  sheets.  If,  however,  the  goods 
and  the  expenses  cost  less  than  $100,000,  so  that  profit  was 
made,  and  that  profit  made  was  distributed  as  dividends,  the  new 
balance  sheet  will  show  no  change  at  all  for  these  transactions  as 
compared  with  the  old.  The  succession  of  values  under  the  sup- 
position above  will  run  as  follows: 


Debits 

Credits 

Cash 

Accts.  Rec* 

100,000 

Mdse. 

Cash 

(say) 

80,000 

Expenses 

Cash 

(say) 

10,000 

Accts.  Rec. 

Mdse. 

100,000 

Loss  and  Gain 

Expenses 

10,000 

Mdse. 

Loss  and  Gain 

20,000 

Loss  and  Gain 

Dividends 

10,000 

Dividends 

Cash 

10,060 

Checking  these  up  will  show  in  the  end  no  change  in  any  account, 
and  so  no  change  on  the  balance  sheet.  In  other  words,  when  the 
operations  not  only  produce  no  ultimate  increase  or  decrease  in 
assets  but  convert  old  assets  into  new  assets  of  the  same  t3^e, 
as  in  our  illustrations  above,  they  produce  no  effect  on  the  bal- 
ance sheet.     Usually,  however,  operations  not  only  produce  a 


348  THE  FUNDAMENTALS  OF  ACCOUNTINO 

change  in  total  of  net  assets  but  also  a  change  in  the  character  of 
assets  —  for  conversions  are  hardly  likely  exactly  to  replace 
themselves  in  kind.  We  will  usually  have  more  or  less  cash,  more 
or  less  merchandise,  more  or  less  in  accounts  receivable  and  in 
accounts  payable,  even  when  the  net  assets  are  the  same.  The 
purpose  of  the  summary  of  balance-sheet  changes  is  to  show  just 
this,  so  that  we  may  see  whether  we  have  more  or  less  of  the  de- 
sirable things. 

Classification  of  Balance-Sheet  Changes.  We  have  observed 
that  the  changes  themselves  must  be  in  two  sets,  and  in  balance. 
This  is  not  only  mathematically  reasonable  but  plain  business 
common  sense.  If  we  have  less  of  some  type  of  asset  than  we  had 
a  year  ago,  we  have  more  of  some  other  asset,  have  paid  off  debt, 
have  drawn  out  investment,  or  have  suffered  a  loss;  but  these 
things  also  will  show  on  the  summary  of  changes.  Our  changes 
group  themselves  into  two  classes:  debit  changes,  and  credit 
changes.  An  addition  to  assets  and  a  decrease  in  ownership- 
claims  constitute  debit  changes,  and  a  decrease  in  assets  and  an 
increase  in  ownership-claims  constitute  credit  changes.  Debit 
changes  must  equal  credit  changes  —  or  else  one  of  our  balance 
sheets  used  for  comparison  is  out  of  balance.  It  happens  that 
debit  changes  always  indicate  what  was  done  with  values  which 
were  in  possession,  and  credit  changes  indicate  where  values  came 
from:  for  debit  changes  show  either  an  increase  in  assets  (putting 
values  into  the  form  shown  by  the  balance  sheet  as  increased),  or 
a  decrease  in  ownership-claims  (paying  off  debt  or  withdrawing 
by  owners) ;  and  credit  changes  show  either  reduction  of  assets 
(value  converted  out  of  the  form  shown  by  the  earlier  balance 
sheet),  or  an  increase  in  ownership-claim  (receiving  value  from 
loan,  investment,  or  profit  from  operation) .  Debit  changes,  then, 
show  what  was  done  with  values,  destinations,  and  credit  changes 
show  where  value  came  from,  sources.  Let  us  now  take  two  ab- 
breviated balance  sheets  of  the  same  business,  and  tabulate  the 
changes,  labeling  debit  changes  "  application  of  values,"  and 
credit  changes  "  sources  of  values,"  and  carrying  to  "  application 
of  values "  all  increases  of  assets  and  decreases  of  ownership- 
claims,  and  to  "  sources  of  values  "  all  decreases  of  values  and 
increases  of  ownership-claims. 


,  INTERPRETATION  OF  FINANCIAL  STATEMENTS      349 

Comparative  Balance  Sheets 


Jan.  I,  1922 

Jan.  1, 1923 

Cash 

$12,400 

$     5,900 

Merchandise 

64,000 

93,000 

Accounts  Receivable 

86,000 

128,000 

Raw  Material 

20,000 

30,000 

Goods-in-Process 

40,000 

50,000 

Allowance  for  Discounts  Available 

2,600 

2,100 

Fixtures 

3,000 

2,000 

Machinery 

87,000 

87,000 

Real  Estate 

40,000 

50,000 

$355,000 

$448,000 

Accounts  Payable 

$69,000 

$53,000 

Notes  Payable 

35,000 

19,000 

Accrued  Liabilities 

8,000 

2,000 

Allowance  for  Bad  Debts 

2,000 

3,000 

Allowance  for  Discounts  Offered 

3,000 

4,000 

Allowance  for  Depreciation 

14,000 

19,000 

Provision  for  Fire  Hazard 

15,000 

20,000 

Capital  Stock 

200,000 

250,000 

Surplus 

9,000 

78,000 

$355,000 

$448,000 

In  the  table  following,  plus  and  minus  signs  are  used,  for  conven- 
ience, in  showing  whether  the  change  is  one  of  increase  or  of  de- 
crease. All  in  the  same  column  are  to  be  added,  however,  what- 
ever the  sign  used,  for  a  decrease  in  a  h'ability  is  just  as  much  an 
application  of  value  as  is  an  increase  in  an  asset. 

Summary  of  Balance-Sheet  Changes 


Application  0}  valttes 

Source  of  values 

Merchandise  (+) 

$29,000 

Cash  (-)                                    $6,500 

Accounts  Receivable  (+) 

42,000 

Allowance  for  Discounts  Avail- 

Raw Material  (+) 

10,000 

able  (— )                                          500 

Goods-in-Process  (+) 

.   10,000 

Fixtures  (— )                                    1,000 

Real  Estate  (+) 

10,000 

Allowance  for  Bad  Debts  (+)         1,000 

Accounts  Payable  (— ) 

16,000 

Allowance  for  Discounts  Of- 

Notes Payable  (-) 

16,000 

fered  (+)                                      1,000 

Accrued  Liabilities  (-) 

6,000 

Allowance  for  Depredation  (-H)       5 .000 
Provision  for  Fire  Hazard  (-f )         5,000 
Capital  Stock  {+)                         50,000 
Surplus  {-{•)                                 69,000 

$139,000 

$139,000 

3SO  THE  FUNDAMENTALS  OF  ACCOUNTING 

The  items  of  debit  change  are  obvious  enough.  The  first  ^ve 
show  more  values  put  into  merchandise,  accounts  receivable,  raw 
material,  goods-in-process,  and  real  estate,  and  the  last  three 
show  a  reduction  of  debt.  On  the  credit  side  the  first  and  the 
third  item  show  a  direct  reduction  of  values  —  cash  spent  and 
fixtures  either  sold  or  depreciated.  The  second,  representing  a 
shrinkage  in  the  hole  in  a  liability,  really  increased  the  liability, 
and  shows  the  source  of  values.  The  next  four  items  show  in- 
creased holes  in  the  assets,  and  hence  are  a  source  of  assets  only  in 
the  mathematical  sense:  they  are  merely  offsets  to  the  overvalua- 
tion of  assets,  and  might  be  deducted  on  the  other  side,  but  are 
kept  here  for  convenience.  The  last  two  items  constitute  in- 
creases in  proprietorship,  the  former  probably  by  new  investment, 
and  the  latter  by  profits  —  though  the  former  may  have  origi- 
nated in  a  stock  dividend;  we  have  no  way  from  the  balance  sheet 
alone  of  determining  this  matter. 

Interpreting  Balance-Sheet  Changes.  On  the  face  of  things 
four  changes  stand  out  as  favorable  —  the  decHne  in  accounts 
payable,  notes  payable,  and  accrued  liabih'ties  (showing  not  only 
wiUingness,  but  ability  to  get  out  of  debt),  and  the  increase  of 
surplus  (showing  not  only  the  ability  but  the  wiUingness  to  ac- 
cumulate a  margin  of  safety).  The  cash  decrease  is  apparently 
favorable  unless  payables  are  maturing  more  rapidly  than  re- 
ceivables; for  the  former  cash  balance  looked  unnecessarily  large 
for  the  apparent  size  of  the  business  —  which,  however,  we  shall 
examine  later  in  connection  with  the  operating  statement.  The 
increases  in  merchandise,  accounts  receivable,  raw  material, 
goods-in-process,  and  real  estate,  we  are  not  yet  in  a  position  to 
judge.  These  we  will  return  to  after  we  have  seen  the  operating 
statement. 

The  Form  of  Operating  Statement.  The  operating  statement, 
like  the  balance  sheet,  has  no  standard  form.  The  chief  require- 
ment is  that  it  shall  group  items  of  a  kind,  show  the  relation 
between  groups,  and  not  introduce  into  any  group  items  which 
confuse  the  relations  of  that  group  with  any  other.  This  was 
discussed  in  connection  with  clearing  accounts  in  Chapter  VIII. 
Below  is  shown  an  operating  statement  introducing  virtually  all 
the  nominal  accounts  discussed  in  Chapter  VIII.    It  also  shows 


INTERPRETATION  OF  FINANCIAL  STATEMENTS      351 

the  transactions  for  an  earning  period  of  the  busmess  for  which 
two  balance  sheets  were  given  in  the  preceding  paragraph. 
OPERATING  STATEMENT.  JANUARY  i.  igaa— DECEMBER  31, 1929 


Um:  OiacouBU  Gives  laS.ooo    '""''^ 

Uacspired  Dtacouats  Offered  4,000       33.000 

__  Net  rQJl(^:tible  from  Mies  %Ktninon 

PWibtd  Good*  lovcatory.  Jut.  i.  iftts  I64.OOO    **^*'**' 

Cood^ift'IYowi  lavcatonr.  Jmi.  i.  igaa 
mw  Material  lavcatory.  Jaa.  1, 19M 
PlUciMM  Raw  Material  |l6l.om 

LOH  Retimed  PurchaMi  7.000 

NctpwckaaH  |i6i!ooo 


Uaopired  Diacta.  AviAablt     i,ioo        6.S00 
Net  cost  of  pvrchaaea  i54«500 

itcrial  handled  $174^00 

LcM  Raw  Material  lavcntory.  Jaa.  i.  IMS  jo.000 

Coat  of  raw  aaatcrial  ooaMmad  UAJM 

Wai«  |a9a.6so  ^*^ 

•  000 
S^ooo 


sr 

J9.000 
J.000 

iSiSTSiSk 

4.000 

&SSS^ 

JiS 

tipMiri  diitribtttabic 

|iZ4i2S2 

aMrrlo  maaafactwteg 

ttt.000 

Oort  oTjooda  MaBaf  actured 
Um  Coodi  Id  ProceM  lavcntonr.  In.  I.  IQU 

50.000 

OootafsoodifiaUhed 

I41S.SOO 

rotated  toods  haMltod 

I479.500 

U«  FWAad  Goodi  lavcaton 

r.JaB.x,i9lS 

' 

93.000 

QMtoftoodieold 

•H^^^aa^ 

386J00 

CraM  profit  f  roat  Mlet 

I192.500 

UwSeBiMibareofdlatrfciimili  iij— (Im,00a»  lD(M>00 

U«fa«ai  Bad  Debta 

U.000 

DcteUMBEftiMtfed 

I  OS  .000 

Lm  riMi«  ol  dattribvtablc  C9 

16^000 
a.ooo 

W7.iOO 

■Mdna^BOQi 

4.000 

NctlaoMM 

I0I.5OO 

DividcMla 

aa.soo 

for  tiM  year  I69.000 

Relation  of  Opentiiic  StatMuent  and  Balance  Sheet  One 
should  remember  that  though  the  operating  statement  consists  of 
nominal  items  and  the  balance  sheet  of  real  items,  many  items  at 
kast  in  name  are  common  to  both.  As  we  saw  in  Chapter  Vn, 
the  books  are  not  kept  complete  currently,  and  at  the  time  ad- 
justments are  made  for  ckxdng  the  books  many  items  of  assets 
and  liabilities  must  be  entered  for  the  first  time  or  be  adjusted; 
and  adjustments  always  relate  to  converted  items  (or  they  woukl 


352  THE  FUNDAMENTALS  OF  ACCOUNTING 

not  need  adjustment),  and  the  operating  statement  is  merely  a 
statement  of  converted  items:  so  the  process  of  closing  the  books 
may  give  us  the  item  for  both  the  balance  sheet  and  the  operating 
statement  —  the  unconverted  portion  for  the  balance  sheet,  and 
the  converted  portion  for  the  operating  statement.  Since,  more- 
over, the  conversions  which  do  not  cancel  each  other  represent 
increase  or  decrease  in  proprietorship,  they  get  upon  the  balance 
shqet  in  that  form  (as  proprietors'  claim  to  assets  derived  from 
profits,  or  shrinkage  of  claim  because  of  losses).  Here,  for  ex- 
ample, we  have  eleven  items  recognizable  as  common  to  the  two 
sheets,  and  one  item  which  would  be  recognizable  if  it  were  not 
a  merger  of  several  items  for  convenience.  These  follow  in  the 
order  of  their  appearance  on  the  operating  statement:  Unexpired 
Discounts  Offered  is  a  reduction  of  income  on  the  operating 
statement,  and  the  complementary  credit  is  to  Allowance  for 
Discounts  Offered,  which  appears  on  the  second  balance  sheet; 
Finished  Goods  Inventory  is  twice  on  each  set  of  figures  —  the 
inventory  for  Jan.  i,  1922,  is  credited  to  the  old  nventory  account 
and  is  debited  to  the  clearing  account  for  Merchandise  (thus  get- 
ting on  the  operating  statement),  and  the  new  inventory  is  debited 
to  the  new  inventory  account  and  is  credited  to  the  clearing  ac- 
count for  Merchandise;  Goods-in-Process,  and  Raw  Material, 
similarly  appear  twice  in  each  set  of  figures;  Unexpired  Discounts 
Available  is  a  reduction  of  costs  on  the  operating  statement,  and 
the  complementary  debit  is  to  Allowance  for  Discounts  Available, 
which  appears  on  the  second  balance  sheet;  the  accrued  liabilities 
of  $2,000  shown  at  the  end  are  for  various  expenses  included  in 
<^>erating  costs,  but  merged  for  convenience;  Depreciation  on  the 
operating  statement  matches  the  increase  in  Allowance  for  De- 
preciation on  the  balance  sheet  —  and  this  shows  that  the  writing 
down  of  Fixtures  on  the  balance  sheet  was  due  not  to  depreciation 
but  to  sale  or  exchange,  for  otherwise  Depreciation  would  be 
debited  $6,000  ($5,000  from  the  increase  in  the  allowance  and 
$1,000  from  the  decrease  in  fixtures);  Debt  Loss  Estimated  is  a 
cost  on  the  operating  statement,  and  the  complementary  credit  is 
to  Allowance  for  Bad  Debts,  which  appears  on  the  second  balance 
sheet;  Surplus  on  the  operating  statement  is  the  final  figure,  meas- 
uring the  excess  of  credits  to  nominal  accounts  over  the  debits  to 


mXERPRETATION  OF  FINANCIAL  STATEMENTS      353 

nominal  accounts,  and  hence  the  increase  of  proprietorship  by 
conversions,  added  on  the  balance  sheet  to  the  previous  surplus; 
and  as  the  new  assets  and  liabilities  arising  from  the  conversions 
have  also  been  carried  by  adjustment  to  the  balance  sheet,  as  we 
have  just  seen,  this  brings  both  sides  of  the  balance  sheet  into 
accord  with  the  present  status. 

Relation  of  Balance-Sheet  Changes  and  Operating  Statement. 
We  postponed  discussion  of  the  increase  of  Merchandise,  Ac- 
counts Receivable,  Raw  Material,  Goods-in-Process,  and  Real 
Estate,  until  we  could  see  the  operating  statement.  Indeed,  we 
need  two  operating  statements,  or  at  least  parts  of  the  preceding 
statement  for  comparison  with  the  new.  Suppose  we  find  that 
the  preceding  statement  shows  us  net  sales  of  $470,000.  What 
tendencies  does  the  new  operating  statement  show?  First,  we 
find  an  increase  of  sales  in  1922  amounting  to  30%  ($611,000  as 
compared  with  $470,000  in  192 1).  Now  we  can  form  some  judg- 
ment about  balance-sheet  increases  of  assets  on  Jan.  i,  1923,  as 
compared  with  assets  on  Jan.  i,  1922.  We  find  the  inventory  of 
merchandise  or  finished  goods  on  Jan.  i,  1923,  $29,000  larger  than 
on  Jan.  i,  1922  —  an  increase  of  45%  ($93,000  as  compared  with 
$64,000) ;  and  yet  we  have  just  found  the  business  increasing  only 
30%.  Is  it  favorable  to  accumulate  a  45%  increase  of  stock  with 
only  a  30%  increase  of  sales?  Raw  Material  has  increased  50%. 
Accounts  receivable,  again,  show  an  increase  of  49%  (an  increase 
of  $42,000  over  the  $86,000  of  Jan.  i,  1922),  and  yet  sales,  as  we 
have  seen,  increased  only  30%.  Does  this  mean  slower  collec- 
tions and  accumulation  of  bad  accounts?    Let  us  examine  this. 

Accounts  Receivable  and  Sales.  Suppose  we  now  consult  the 
books  and  find  some  facts  about  the  previous  year.  Suppose  we 
find  that  on  Jan.  i,  192 1,  the  balance  of  Accounts  Receivable  was 
$73,000,  and  that  in  192 1  the  discounts  given  to  customers  on 
sales  of  that  year  were  $19,000.  Suppose  we  also  find  that  in 
192 1  the  discounts  chargeable  to  the  Allowance  for  Discounts 
Offered  set  up  in  the  previous  year  was  $2,000,  and  in  1922 
was  $2,500.  Now  we  are  in  a  position  to  learn  how  the  discounts 
of  1922  compare  with  the  discounts  of  1921.  We  must  first 
find  the  amount  of  accounts  receivable  settled  in  each  of  these 
years,  thus: 


354  THE  FUNDAMENTALS  OF  ACCOUNTING 

Accounts  Receivable  on  balance  sheet,  1/1/21,  $73,000;  1/1/22,  $86,000 

Sales  of  1921,     470,000;  1922,     611,000 

Collectible  in  1921,    $543,000;  1922,    $697,000 

Accounts  Receivable  on  balance  sheet,  1/1/22,    86,000;  1/1/23,128,000 

Accounte  settled  in  1921,    $457,000;  1922,    $569,000 

The  next  step  is  to  show  what  discounts  were  actually  taken  on 
these  settled  bills. 

Discounts  given  (in  year,  for  year)  1921,  $19,000;  1922,  $28,000 
Discounts  charged  in  later  year  to 

allowance  of  earlier  year               1921,  2,000;  1922,      2,500 

Total  discounts  on  settlements  of    1921,  $21,000;  1922,  $30,500 

Percentage  of  discounts  to  settlements  4-6%                5-4% 

We  find,  then,  that  the  average  discount  rate  is  higher  on  the  sales 
of  1922  so  far  settled  than  on  those  of  1921 ;  and  if  there  has  been 
no  change  in  the  general  level  of  rates  offered,  it  is  obvious  that 
payments  are  quite  as  prompt  —  else  the  discounts  could  not 
have  been  taken.  The  writing  off  of  any  accounts  as  bad  debts, 
moreover,  tended  to  reduce  this  average  (raising  the  figure  of  set- 
tlements but  not  that  of  discounts).  Only  in  case  the  doubtful 
accounts  have  been  carried  on  the  books  longer  in  1922  than  in 
192 1,  which  there  is  no  reason  to  suppose,  could  the  figure  of 
average  discount  as  calculated  fail  to  prove  that  collections  were 
better  in  1922  than  in  192 1.  How  then  explain  a  49%  increase  in 
accounts  receivable  with  only  a  30%  increase  in  sales?  Will  col- 
lections from  accounts  receivable  keep  pace  with  increases  in  sales, 
precede  them,  or  follow  them?  Sales  of  October  are  collectible  in 
late  October  or  November;  many  of  the  sales  of  December  are  not 
collectible  until  January.  As  long  as  a  business  is  growing,  then, 
its  collections  never  catch  up  with  its  sales;  for  while  bills  are  ma- 
turing sales  are  piling  up  faster;  but  a  period  of  equilibrium  or  of 
decline  enables  collections  to  catch  up. 

General  Efifect  of  Expansion.  Similarly,  unless  a  business  can 
increase  its  rate  of  turnover,  its  stock  of  goods  must  increase 
ahead  of  its  sales  (for  a  business  does  not  ordinarily  sell  goods  that 
it  does  not  possess) ;  so  that  the  reason  for  stocks  of  goods  running 
ahead  of  sales  is  the  reverse  of  that  under  which  accounts  receiv- 
able balances  keep  ahead  of  sales.    As  a  general  tendency,  what 


INTERPRETATION  OF  FINANCIAL  STATEMENTS      355 

we  have  just  seen  to  be  true  of  a  growth  of  inventory  of  mer- 
chandise is  equally  true  of  a  growth  of  inventory  of  raw  material 
and  of  goods-in-process.  They  are  procured  in  anticipation  of 
expansion;  but  they  may  run  behind,  as  goods-in-process  does 
here,  perhaps  because  of  lack  of  labor.  Real  estate,  again,  may 
need  expansion  with  growing  sales,  and  may  run  ahead  of  or  be- 
hind that  expansion,  according  to  circumstances.  In  the  case 
before  us,  these  expansions  all  look  reasonable,  as  they  would 
hardly  do  were  sales  running  more  slowly.  We  wonder  now 
whether  the  decrease  in  cash  is  on  the  whole  fortunate.  We  can- 
not tell,  however,  without  a  fuller  statement  of  maturities  of 
assets  and  liabilities,  such  as  was  given  on  page  342. 

These  Studies  T3rpical.  The  fragmentary  interpretation  of  the 
balance  sheets  and  the  income  sheet  just  given  is  meant  to  be 
suggestive  only.  A  multitude  of  relations  in  any  active  business 
are  Hkely  to  be  worth  study,  especially  when  combined  with  sta- 
tistics not  shown  in  financial  figures,  as  hinted  at  in  Chapter  XV. 
Great  care  must  be  taken,  however,  not  to  form  judgments  of 
importance  on  insufficient  evidence.  Usually  many  facts  not 
shown  on  either  income  sheets  or  balance  sheets  must  cast  side- 
lights on  those  sheets  before  anything  like  a  final  black  or  white 
judgment  of  a  business  is  possible. 

Statement  of  Affairs.  Akin  to  the  analyzed  balance  sheet 
shown  on  page  342,  for  a  business  that  is  solvent  and  is  continu- 
ing, is  a  form  of  statement  for  businesses  about  to  be  liquidated. 
We  have  already  seen  that  the  value  of  assets  in  liquidation  is 
commonly  very  different  from  the  value  of  the  same  assets  in 
natural  gradual  conversion.  The  books  cannot  show  liquidation 
values  —  at  least  until  after  the  event  —  but  in  laying  out  a 
course  of  procedure  in  Hquidation  one  must  use  values  in  advance 
of  the  event.  Since,  moreover,  specific  assets  are  often  pledged 
for  the  payment  of  particular  liabihties,  one  cannot  know  how 
much  will  be  available  for  the  payment  of  unsecured  habilities 
until  all  liabilities  specially  secured  have  been  set  off  against  the 
assets  appHcable  to  them.  Hence  a  form,  called  a  "statement  of 
affairs,"  is  used,  for  a  business  about  to  be  liquidated,  in  such  a  way 
as  to  show  what  assets  are  applicable  to  what  liabihties  and  how  far 
the  assets  are  adequate,  or  more  than  adequate,  for  that  purpose. 


3S6  THE  FUNDAMENTALS  OF  ACCOUNTING 

Principle  of  Arrangement  of  Statement  of  Afifairs.  Since  the 
purpose  of  a  statement  of  affairs  is  to  show  adequacy  or  inade- 
quacy of  assets,  the  grouping  of  items  has  regard  largely  to  can- 
cellations of  assets  against  liabilities  in  two  general  ways:  pledged 
assets  are  set  off,  item  by  item,  against  the  specific  liabilities 
which  they  protect,  and  then  the  surplus  value  of  pledged  assets 
(above  the  secured  claims  against  them)  and  the  value  of  un- 
pledged assets  are  set  off  as  a  lump  sum  against  the  unsecured 
liabilities,  so  as  to  show  the  deficiency  (or  insolvency)  on  one  hand 
or  the  balance  of  proprietorship  on  the  other.  Since,  moreover, 
in  drawing  up  such  a  statement  it  is  easy  to  omit  or  duplicate 
some  item  or  part  of  an  item  by  inadvertence,  it  is  desirable  to 
incorporate  in  the  statement  figures  from  the  trial  balance  or  the 
balance  sheet  by  way  of  proof.  If  any  allowance  accounts  are  on 
the  books,  it  is  well  to  show  both  the  gross  and  the  net  book  value 
of  assets  as  a  check  against  error  and  as  assurance  that  all  balance- 
sheet  figures  have  been  utilized  and  accounted  for. 

Detail  of  Arrangement  of  Statement  of  Afifairs.  It  is  well  to 
show  sources  of  figures,  so  that  it  will  be  clear  that  none  have  been 
juggled.  If  we  begin  with  liabilities,  as  is  common,  we  will  divide 
them  into  groups  according  to  security  —  those  wholly  secured, 
those  partly  secured,  and  those  unsecured.  Usually  those  wholly 
secured  are  still  further  subdivided  into  those  having  a  preference 
by  law  without  special  security,  commonly  called  "preferred 
claims,"  chiefly  wages,  taxes,  and  expenses  of  liquidation,  and 
those  secured  by  contract.  Under  those  preferred  by  law  will  be 
placed  the  assets  available  for  meeting  them;  and  if  the  immedi- 
ately available  assets  are  inadequate  the  amount  is  extended  as  a 
claim  against  other  assets,  whereas  if  a  surplus  is  shown  it  is  car- 
ried to  the  other  side  of  the  statement  as  available  for  meeting 
unsecured  claims.  It  is  well  to  show  the  full  figure  wherever  an 
item  is  used  —  to  show  that  no  juggling  has  taken  place.  In 
the  form  following,  for  example,  though  only  $i,ooo  of  cash  is  to 
be  applied  to  expenses  of  liquidation,  it  is  well  to  show  the  whole 
$3,000  available  for  payment.  When  property  is  pledged,  but  is 
not  worth  the  book  value,  it  is  well,  in  connection  with  the  liabil- 
ity, to  show  both  the  book  value  and  the  estimated  value  —  in 
order  that  all  the  relationships  may  appear  in  their  natural  con- 


INTERPRETATION  OF  FINANCIAL  STATEMENTS      357 

text.  On  the  assets  side  it  is  well  to  show  three  columns,  one  for 
ledger  values,  one  for  net-ledger  values,  and  one  for  estimated 
available  balances  applicable  to  unsecured  claims.  The  net- 
ledger  column  is  to  show  the  net  value  of  assets  after  any  allow- 
ances have  been  subtracted  and  after  any  applications  have  been 
made  of  those  particular  assets  to  secured  claims  already  shown 
on  the  ledger;  that  is,  the  purpose  is  to  show  any  values  that  will 
remain  on  the  ledger  after  debits  and  credits  have  been  set  off 
against  one  another  as  far  as  they  will  go.  Then  the  difference 
between  the  net-ledger  value  and  the  estimated  available  value 
represents  the  shrinkage  in  values  through  Uquidation  —  a  matter 
of  large  statistical  importance.  It  is  well,  when  of  any  particular 
type  of  assets  some  are  pledged  and  some  are  not,  to  show  the 
total  in  the  ledger  column,  agreeing  with  the  balance  sheet,  separate 
them  in  the  net-ledger  column,  and  continue  the  subdivisions  in 
the  last  column.  The  difference  between  the  last  column  on  the 
assets  side  and  the  last  on  the  liability  side  is  the  deficiency  in  case 
of  insolvency,  or  the  net  worth  in  case  of  solvency.  No  standard 
form  is  in  use,  however;  the  whole  matter  is  one  of  making  clear 
all  the  necessary  relations. 

Illustration  of  Statement  of  Affairs.  For  illustration  by  a  sim- 
ple case,  let  us  start  with  a  balance  sheet,  make  certain  additional 
suppositions  about  values  and  pledges  and  liabilities,  and  proceed 
to  a  statement  of  affairs.    The  balance  sheet  follows: 


Cash 

$  3,000 

Proprietor 

$I5jOOO 

Accts.  Receivable 

IO,OCX3 

Accts.  Payable 

18,000 

Merchandise 

20,000 

Notes  Payable 

4,000 

Fixtures 

4,000 

$37,000  $37,000 


The  notes  payable  are  secured  by  a  lien  on  merchandise  having  a 
book  value  of  $10,000,  and  $3,000  of  the  accounts  payable  are 
secured  by  a  lien  on  accounts  receivable  having  a  book  value  of 
$6,000.  The  expenses  of  liquidation  are  estimated  at  $1,000. 
Of  the  accounts  receivable,  $7,000,  including  the  $6,000  pledged, 
are  estimated  good,  $2,000  doubtful  (probably  50%  good),  $1,000 
bad.  The  fixtures  are  worth  $1,000,  the  merchandise  pledged  is 
deemed  worth  $3,500  and  the  rest  of  the  merchandise  $4,500. 


358 


THE  FUNDAMENTALS  OF  ACCOUNTING 


Statement  of  Affairs 
LiabUUies 


Preferred  claims 
Expense  of  liquidation  estimated 
Cash  available 
Balance  shown  contra 
Fully  secured  claims 
Accounts  Payable  (part) 
Accounts  Receivable  pledged 
Balance  shown  contra 
Partly  secured  claims 
Notes  Payable 
Merchandise  pledged  $10,000 
Estimated  value  of  merchandise  pledged 
Balance  imsecured 
Unsecured  claims 

Accounts  Payable  (balance,  $18,000  —  $3,000) 
Totals 

Assets 


Ledger 

Claim 
against 
general 
assets 

$1,000 

3,000 

$2,000 

$3,000 

$3,000 

6,000 

$3,000 

$0,000 

$4,000 

4,000 

3,500 

500 

15,000 

15,000 

$22,000 1 

$15,500 

Cash 
Less  expenses  of  liquidation 
Balance  available 

Accounts  Receivable 
Pledged,  good  $6,000 

Less  required  for  Accounts 

Payable  3,000 

Balance  available  $3,000 

Unpledged 

Good 

Doubtful 

Bad 

Merchandise 
Pledged 
Estimated  value  $3,Soo 

Lien  for  Notes  Payable  4,000 

Balance  liability  (contra)  $500 

Unpledged 
Fixtures 
Totals 
Deficiency 


>  This  figure,  |33,ooo.  plus  the  proprietor's  balance,  proves  with  the  balance-sheet  total  of  l37iOoa 

•  This  total  agrees  with  the  balance  sheet. 

•  The  difference  between  these  totals  shows  the  estimated  loss  on  liquidation,  including  expenses. 


LeAger 

Net 
Ledger 

Estimated 

availabk 

value 

$3,000 
1,000 

$3,000 

$3,000 

$2,000 

$2,000 

$10,000 

6,000 

10,000 

3,000 
4,000 

3,000 

$4,000 

$1,000 

1,000 

2,000 

1,000 

1,000 

20,000 

6,500 

$20,000 
10,000 

$10,000 

4,000 

10,000 
4,000 

4,500 
1,000 

$37,ooo2 

$30,500' 

$I2,500» 

3,000 

$15,500 

INTERPRETATION  OF  FINANCIAL  STATEMENTS      359 

Deficiency  Statement.  It  is  well  now  to  have  a  summary 
statement  showing  the  causes  of  deficiency  and  the  net  effect. 
A  deficiency  does  not  begin  until  the  proprietor's  ownership  is 
wiped  out;  so  that  whereas  a  deficit  is  loss  of  owner's  property,  a 
deficiency  is  loss  of  other  people's  property  after  the  owner's 
property  is  all  gone.  When  we  have  a  deficiency,  then,  we 
wish  to  see  how  much  of  each  kind  of  ownership-claim  was  lost. 
The  middle  column  of  the  assets  side  of  the  statement  of  affairs 
shows  the  net  value  of  the  assets  —  that  is,  the  ledger  value  of 
assets  less  any  allowances  (in  this  case  none)  and  any  applications 
of  assets  to  Uabilities  shown  on  the  ledgerf  and  the  last  column 
shows  what  is  estimated  to  be  available,  from  that  net-ledger 
value,  to  pay  unsecured  claims:  the  difference  between  them  is 
clearly  shrinkage  in  realization.  The  items  of  shrinkage  may  be 
expressed  as  Causes  of  Deficiency,  as  shown  below.  The  effect  of 
the  causes  oi  loss  must  exactly  equal  the  total  measure  of  all  the 
kinds  of  ownership  lost.  This  gives  us,  for  the  case  above,  the 
statement  given  below. 

Deficiency  Statement 


Causes  of  loss 

Whose  property 

was  lost 

Expenses  of  liquidation 
(3,000—2,000  cash) 
Loss  on  accounts  receivable 

$1,000 
2,000 

Proprietor 
Deficiency 

$15,000 
3,000 

(4,000-2,000) 
Loss  on  merchandise 

(16,500-4,500) 
Loss  on  fixtures 

12,000 
3,000 

(4,000-1,000) 

$18,000 

$18,000 

36o 


THE  FUNDAMENTALS  OF  ACCOUNTING 


QUESTIONS  AND  PROBLEMS 
I.  (a)  What  specific  information  is  given  by  the  following  statement? 

Trial  Balance,  December  31,  1924 
Capital  Stock 


Bills  Payable 

Accounts  Payable 

Merchandise 

Accounts  Receivable 

Fixtures 

Wages  and  Salaries 

Advertising 

Commission 

Rent 

General  Expense 

Petty  Cash 

Cash 

Surplus 


$47,000 

7,000 

87,000 

7,000 

4,000 

22,000 

100 

2,000 


$100,000 
20,000 
30,000 
10,000. 


2,100 


14,000 


$176,100        $176,100 


(b)  Can  the  following  statement  refer  to  the  same  business  as  of  the 
same  date?  If  so,  explain  the  discrepancies.  If  not,  what  information 
does  the  second  statement  give? 

Capital  Stock  $100,000 

Bills  Payable  20,000 

Accounts  Payable  30,000 

Allowance  for  Bad  Debts   3,000 
Accrued  Wages  2,000 

Surplus  4,850 


Merchandise 

$105,000 

Accounts  Receivable 

47,000 

Fixtures 

S,Soo 

Commissions  Earned 

300 

Cash 

2,050 

$159,850 


$159,850 


2.  A  business  had  th«  following  balance  sheet  on  January  i,  192 1: 


Real  Estate 

$40,000 

Capital  Stock 

$60,000 

Plant 

20,000 

Notes  Payable 

23,000 

Raw  Material 

17,000 

Accounts  Payable 

40,000 

Goods-in-Process 

16,000 

Accrued  items 

7,000 

Finished  Goods 

12,000 

Accounts  Receivable 

18,000 

Fixtures 

4,000 

Cash 

3,000 

$130,000 


$130,000 


During  the  year  it  bought  $25,000  worth  of  raw  material,  paid  for 
$30,000  of  raw  material,  issued  $40,000  worth  of  raw  material,  paid 
$50,000  in  wages  (including  $3,000  accrued  brought  over  from  the 


INTERPRETATION  OF  FINANCIAL  STATEMENTS      36I 

year  before),  paid  $30,000  of  general  expenses  (including  $4,000  of  old 
accrued  items),  sold  $160,000  of  finished  goods,  collected  $140,000  on 
sales,  and  paid  $9,000  in  dividends.  Its  balance  sheet  a  year  later  was 
as  follows: 


Real  Estate 

$35,000 

Capital  Stock 

$60,000 

Plant 

18,000 

Notes  Payable 

5, 000 

Raw  Material 

2,000 

Accounts  Payable 

35,000 

Goods-in-Process 

18,000 

Accrued  Items 

8,000 

Finished  Goods 

9,000 

Allowance  for  Bad 

Accounts  Receivable 

34,000 

Debts 

S,ooo 

Fixtures 

4,000 

Surplus 

13,000 

Cash 

6,000 
$126,000 

$126,000 

(a)  Show  summary  journal  entries  for  all  the  transactions  of  the 
year,  and  check  them  with  the  new  balance  sheet. 

(b)  Show  the  income  sheet. 

(c)  Show  in  a  statement  the  sources  and  application  of  values  utilized 
dining  the  year.  What  does  the  statement  tell  you  about  the  condi- 
tion of  the  business? 


3.  A  trial  balance  of  ledger  totals  at  the  close  of  business  for  a  year  reads 
as  follows: 

Partner  A 

Partner  B 

Partner  A  Salary 

Partner  B  Salary 

Bills  Payable 

Bills  Receivable 

Accounts  Payable 

Accounts  Receivable 

Merchandise 

Fixtures 

Salaries  and  Wages 

Rent 

Taxes 

Insurance 

Interest 

Freight  and  Cartage 

Advertising 

Other  Expenses 

Loss  by  Bad  Debts 

Cash 


86,000 

58,000 

4,000 

6,000 

5,000 

5,000 

18,000 

23,000 

21,000 

18,000 

195,000 

215,000 

285,000 

200,000 

258,000 

327,000 

8,000 

70,000 

Z2,000 

1,000 

600 

7,700 

1,050 

18,000 

6,650 

18,000 

9,000 

938,000 

938,000 

362  THE  FUNDAMENTALS  OF  ACCOUNTING 

The  income  sheet  was  reported  as  follows: 


Sales 

$368,000 

Less  returned  sales 

15,000 

Net  sales 

Inventory  at  beginning 

$44,000 

Purchases 

$199,000 

Less  returned  purchases 

19,000 

Net  purchases 

180,000 

Merchandise  handled 

$224,000 

Inventory  at  end 

85,000 

Cost  of  goods  sold 

Gross  profit 

Salaries  and  wages 

$73,000 

Rent 

12,000 

Taxes 

1,000 

Insurance 

400 

Interest 

7,600 

Freight  and  cartage 
Advertising 

1,050 
18,000 

Loss  by  bad  debts 

18,000 

Other  expenses 

6,650 

Net  profit 

Partner  A  share 

$7,500 

Partner  B  share 

S,ooo 

Reserve  for  losses  and  shrinkages 

3,800 

$293,000 


139,000 
$154,000 


137,700 
$16,300 

16,300 

(a)  Show  the  balance  sheet,  in  a  form  similar  to  that  shown  on 
page  345,  for  the  beginning  of  the  new  year. 

(b)  What  comment  have  you  to  make  on  the  handling  of  merchan- 
dise on  the  books? 

(c)  How  far  are  the  figures  reported  for  purchases  and  sales  consist- 
ent with  the  figures  of  the  trial  balance? 

How  much  necessary  information,  if  any,  does  the  following  balance 
sheet  fail  to  give  about  solvency:  i.e.,  what  questions,  if  any,  need 
answering  from  other  sources  before  the  intelligent  reader  can  judge  of 
solvency?  [Give  your  answer  in  the  form  of  questions  only,  or  state 
that  no  further  information  is  necessary.) 

Capital  Stock  $200,000 

Notes  Payable  50,000 

Accounts  Payable  75, 000 

Reserve  for  Depreciation  25,000 
Surplus  70,000 


Real  Estate 

$100,000 

Merchandise 

100,000 

Notes  Receivable 

60,000 

Accounts  Receivable 

85,000 

Goodwill 

52,000 

Fixtures 

15,000 

Cash 

8,000 

$420,000 

$420,000 


(a)  How  much  do  the  two  balance  sheets  below  tell  you  about  the 
operations  of  the  year  elapsed  between  their  dates? 


INTERPRETATION  OF  FINANCIAL  STATEMENTS      363 

(b)  Are  there  any  fundamental  facts  about  that  year's  business  which 
these  sheets  cannot  tell  you? 

(c)  Explain  why  your  answer  to  (b)  is  what  it  is. 

(d)  Where  are  the  profits? 


igi6 

1917 

1916 

1917 

Mdse. 

$50,000 

$60,000 

Cap.  Stock 

$75,000 

$75,000 

Accts.  Rec. 

75,000 

55,000 

Bills  Pay. 

20,000 

15000 

Fixtures,  etc. 

14,000 

13,000 

Accts.  Pay. 

40,000 

20,000 

Cash 

6,000 

4,000 

Allow.  Bad  Debts 

3,750 

2,750 

Surplus 

6,250 
$145,000 

19,250 

$145,000 

$132,000 

$132,000 

6.  The  following  statement  of  a  business  for  a  year  was  prepared  by  the 
accoimtant: 


Sales  —  Credits  to  customers  during  year 

$270,000 

Unpaid 

$55,000 

Paid  on  last  year's  sales 

74,000 

Collections  in  excess  of  sales 

$19,000 

Written  off 

1,000 

20,000 

Net  sales  of  year 

$250,000 

Purchases  —  Paid  for  during  year 

$120,000 

Unpaid 

$20,000 

Paid  on  last  year's  purchases 

40,000 

Paid  in  excess  of  purchases 

20,000 

Net  purchases  of  year 

$100,000 

Increase  of  inventory 

10,000 

90,000 

Gross  profit 

$160,000 

Expenses  paid  in  cash 

141,000 

Net  profit 

$19,000 

Dividends  paid  in  cash 

6,000 

Surplus  for  year 

$13,000 

(a)  Could  this  be  for  the  same  business  and  for  the  same  year  as 
are  the  balance  sheets  of  Question  5?  Explain  in  detail. 

(b)  What  is  your  opinion  of  this  as  a  form  of  statement? 

Show  a  Statement  of  Affairs  and  a  Deficiency  Statement  for  the  firm 
of  A  &  B,  whose  condition  is  indicated  below. 


Balance  Sheet 

Cash 

$15,000        Accts.  Payable 

$30,000 

Mdse. 

25,000       Notes  Payable 

27,500 

Accts.  Rec. 

30,000        Partner  A 

17,500 

Equipment 

40,000        Partner  B 

35,000 

$110,000  $110,000 

The  merchandise  is  estimated  worth  $5,000.   The  accotmts  receiv- 
able, divided  into  three  classes,  are  estimated  as  follows:  good,  $5,000; 


364  THE  FUNDAMENTALS  OF  ACCOUNTING 

bad,  $18,000;  doubtful,  worth  probably  50  per  cent,  $7,000.  The  equip- 
ment, estimated  worth  $30,000,  is  pledged  as  security  for  the  notes 
payable.  Accrued  liability  for  wages,  not  on  the  books,  is  $3,000.  Lia- 
bility on  endorsed  protested  notes,  having  no  recoverable  value,  is 
$7,000.  The  expenses  of  liquidation  are  estimated  as  $1,500. 
8.  Show  a  Statement  of  Affairs  and  a  Deficiency  Statement  for  the  fol- 
lowing condition: 

Trial  Balance 


Cash 

200 

Proprietor 

27,700 

Mdse. 

13,400 

Notes  Payable 

10,000 

Accts.  Rec. 

42,500 

Accts.  Payable 

23,400 

Fixtures 

3,000 

Sales 

24,500 

Wages 

17,000 

Office  Expenses 

8,000 

Misc.  Expenses 

1,500 
85,600 

85,600 

There  are  accrued  wages  unpaid  amounting  to  $3,000,  and  accrued 
liabilities  for  advertising,  stationery,  printing,  and  other  office  expenses, 
amounting  to  $2,000.  The  notes  payable  are  secured  by  a  mortgage 
on  the  merchandise.  The  merchandise  is  estimated  salable  for  $4,000, 
and  the  fixtures  for  $500.  The  accounts  receivable  are  estimated  as 
$10,000  good,  $20,000  bad,  and  the  balance  worth  50%.  The  expenses 
of  liquidation  are  estimated  at  $300. 


CHAPTER  XXI 

THE  EFFECT  OF  INTEREST  ON  VALUES 

The  Present  Value  of  Future  Realizations.  It  is  universally 
recognized  that  an  asset  in  hand  to-day  is  worth  more  than  an 
asset  of  the  same  intrinsic  value  which  will  come  to  hand  a  year 
hence.  One  wishes  compensation  for  waiting,  for  one  could  be 
making  use  of  the  asset  (either  earning  profit  or  deriving  pleasure 
or  benefit  from  its  use)  if  one  had  it  now.  Future  realizations,  as 
a  matter  of  simple  business,  then,  are  discounted  in  comparison 
with  present  property.  The  rate  of  interest  to  be  used  for  dis- 
counting does  not  concern  us  here  except  as  we  must  note  that  it 
varies  with  three  conditions:  the  present  market  rate  of  interest, 
the  degree  of  risk  involved  in  the  delay,  and  the  probability  of  a 
change  in  the  market  rate  of  interest  before  the  day  on  which  the 
asset  under  consideration  will  be  realized.  Though  in  a  sense  the 
principle  of  valuation  for  assets  realizable  in  the  future  is  always 
the  same,  it  appears  in  two  aspects  that  may  well  be  observed. 
A  single  value  to  be  realized  at  a  future  time  gives  a  simple  cal- 
culation of  discount;  and  a  series  of  values  to  be  realized  at  succes- 
sive future  times  requires  that  either  many  separate  values  be 
added  together  or  a  formula  be  found  for  making  one  calculation 
for  the  series.  When,  however,  the  series  is  without  limit  of  time, 
though  mathematically  the  principle  is  the  same,  the  practical 
working  method  is  different.  The  value  of  a  single  payment  of 
$i,ooo  due  in  one  year  at  5%  discount  is  $952.38;  of  two  pay- 
ments, the  first  in  one  year  and  the  second  in  two  years,  is 
$1,859.41  (or  $952.38  for  the  first  plus  $907.03  for  the  second); 
but  the  value  of  one  such  payment  a  year  continued  forever  could 
not  be  calculated  by  this  method,  for  there  would  be  no  stopping 
point  —  though  one  would  reach  a  point  at  which  one  would 
see  that  the  value  could  never  go  a  cent  higher  because  the  dis- 
count would  absorb  the  added  $1,000.  The  usual  way  to  calcu- 
late the  value  of  perpetual  payments  is  to  find  what  capital 
would  produce  that  income  and  thus  see  what  the  income  is 
worth — as  we  saw  in  connection  with  the  earning-capacity  basis 


366  THE  FUNDAMENTALS  OF  ACCOUNTING 

of  capitalization.  When  interest  is  5%,  it  takes  $20,000  to  pro- 
duce $1,000  income,  and  hence  a  perpetual  income  of  $1,000  is 
worth  $20,000.^ 

The  Value  of  Stocks.  The  conmionest  kinds  of  future  realiza- 
tions entering  into  business  transactions  are  represented  by  stocks. 
A  share  of  stock  represents  part  ownership  of  a  business,  and  un- 
less that  ownership  is  desired  for  some  other  than  the  usual  reason 
(desire  for  the  income  which  it  may  bring),  its  value  is  dependent 
on  the  probable  earnings  of  the  company.  If  interest  is  5%,  and 
the  stock  holds  good  prospect  of  perpetual  annual  dividends  of 
$5.00  a  share,  it  is  worth  $100  a  share.  If  interest  is  8%  where 
such  risks  are  involved,  and  the  prospect  is  still  for  dividends  of 
$5.00  a  share,  the  stock  is  worth  $62.50  a  share;  but  if  8%  is  satis- 
factory interest  (risk  involved  taken  into  consideration)  and  the 
stock  holds  prospects  of  $12.00  a  share  dividends,  the  stock  is 
worth  $150  a  share.  The  rate  of  interest  used  in  the  calculation 
always  takes  into  consideration  the  risk  involved  —  the  risk  that 
a  lower  rate  may  be  paid,  that  a  loss  may  be  incurred,  that  even 
capital  may  be  sacrificed;  in  other  words,  the  rate  used  at  one  end 
of  the  calculation  is  the  rate  deemed  necessary  under  normal  con- 
ditions to  make  the  investment  attractive,  and  the  amount  of 
dividend  used  at  the  other  is  the  estimated  dividend  of  the  com- 
pany under  normal  conditions.  If  the  two  are  in  agreement,  the 
stock  is  worth  par;  if  the  interest  is  higher  than  the  dividend,  the 
stock  will  be  worth  proportionately  less  than  par,  and  if  the  divi- 
dend is  higher  than  the  interest  the  stock  will  be  worth  propor- 
tionately more  than  par.  This,  it  should  be  noted,  is  supposing 
no  other  considerations  enter  into  the  market.  If,  on  the  other 
hand,  the  stock  is  desired  for  control  (perhaps  by  a  competing 
business),  or  if  stock  has  been  sold  short  on  the  market  and  scar- 
city of  offerings  has  put  it  at  a  scarcity  price,  or  if  a  general  tight- 
ness in  the  money  market  forces  owners  to  sell  in  order  to  raise 
ready  cash,  the  price  may  be  temporarily  very  different  from  that 
naturally  determined  by  earning  capacity.  About  this  there  is 
no  mystery,  and  in  it  no  accounting  is  involved  except  entry  for 
purchase  and  sale  of  stock  and  for  dividends  received.    Similar  to 

1  A  discussion  of  the  simple  mathematics  of  future  realizations  will  be  found  in 
Appendix  C. 


THE  EFFECT  OF  INTEREST  ON  VALUES      367 

it,  however,  are  other  transactions  for  which  neither  the  basis  of 
valuation  nor  the  accounting  is  so  obvious. 

Good  Will.  The  profits  of  many  businesses  exceed  a  normal 
rate  of  return  on  their  capital  or  net  worth;  i.e.,  the  reputation 
which  has  been  built  up  by  the  business,  the  circumstances  under 
which  it  operates,  the  body  of  loyal  employees  which  it  has  gath- 
ered around  it,  lead  to  profits  greater  than  one  can  expect  to  earn 
by  merely  gathering  together  the  necessary  physical  elements  of  a 
successful  business  and  getting  into  the  market.  To  put  this  in 
another  way:  one  would  rather  own  this  old  business  than  start  a 
new  one  with  similar  assets  in  the  form  of  purchasable  buildings, 
machinery,  equipment,  etc.  In  the  degree  that  one  would  rather 
have  the  old  business  one  would  be  willing  to  pay  a  premium  for 
it.  The  amount  which  a  properly  informed  and  properly  equipped 
person  would  pay  as  premium  for  it  is  the  value  of  the  good  will. 
What  determines  the  good  will?  It  is  due  to  the  earning  capacity 
of  the  business  as  an  entity  above  the  earning  capacity  of  equal 
and  similar  assets  dissociated  from  the  business;  and  hence  it  is 
measured  by  the  present  value  of  the  future  earnings  which  are  to 
be  realized  from  the  peculiar  circumstances  of  this  business.  The 
value  of  the  good  will  is  the  capitalized  value  of  its  earnings  above 
normal.  This  may  be  approached  also  from  the  other  end.  If  I 
am  Justified  in  paying  $20,000  for  the  good  will  of  a  business,  it 
must  be  because  I  expect  to  get  back  my  $20,000  or  to  get  an 
additional  income  which  will  be  equivalent  to  a  proper  earning  of 
$20,000  continuously.  If  I  am  not  expecting  to  sell  again,  I  ex- 
pect my  return  to  be  in  the  form  of  earnings  greater  than  I  could 
get  if  I  started  a  new  business  —  else  I  should  never  have  op- 
portunity to  get  any  kind  of  return.  I  may  pay  a  high  price  for 
good  will  not  only  because  present  earnings  are  high  but  because 
future  earnings  are  expected  to  be  higher.  Since  good  will  is  due 
to  the  earning  capacity  of  the  business,  as  a  going  concern,  above 
the  natural  earning  capacity  of  a  similar  set  of  assets  exclusive  of 
good  will,  the  amount  of  good  will  can  be  calculated  very  closely 
provided  one  knows  as  a  basis  the  extra  earning  capacity.  Theo- 
retically, since  the  extra  earnings  usually  come  not  in  large  annual 
payments  but  in  a  steady  small  stream  through  the  year,  the  value 
of  the  good  will  is  the  capitalized  value  of  such  a  steady  stream; 


368  THE  FUNDAMENTALS  OF  ACCOUNTING 

but  since  the  extra  earnings  are  themselves  only  estimated,  al- 
most wholly  problematical,  it  would  be  absurd  to  calculate  to  so 
fine  a  point  as  the  value  of  a  daily  income  as  contrasted  with  an 
annual  income,  and  therefore  the  method  of  calculation  is  sim- 
ply the  capitalized  value  of  the  extra  annual  earnings.  Many  a 
business  has  been  sold  for  an  amount  far  in  excess  of  the  value  of 
its  assets  exclusive  of  the  good  will  and  the  trade  has  been  fair; 
but  many  another  has  been  similarly  sold  and  the  buyers  have 
found  the  good  will  worth  nothing.  Few  things,  indeed,  are  more 
problematical  than  good  will;  for  a  shift  of  fortune  may  destroy  it, 
as  a  shift  of  the  wind  may  destroy  a  yacht's  chance  at  a  prize  that 
is  almost  in  sight. 

Accounting  for  Good  Will.  Because  the  value  of  good  will  is  so 
problematical,  the  usual  practice  in  accounting  is  to  refrain  from 
showing  it  as  an  asset  upon  the  books  unless  it  has  been  paid  for 
by  something  given  in  exchange.  This  practice  has  not  only 
common  sense  but  convenience  to  recommend  it.  To  put  good 
will  on  books  of  account  merely  because  it  has  developed  within 
the  business  is  to  attempt  to  show  changes  in  values  on  the  bal- 
ance sheet,  and  one  might  as  well  show  gain  or  loss  of  proprietor- 
ship through  rises  and  falls  in  the  value  of  real  estate  still  held. 
To  put  on  the  books  what  is  paid  for  good  will  purchased,  how- 
ever, is  to  show  costs,  and  one  must  show  what  was  got  for  what 
was  given  —  unless,  indeed,  one  wishes  to  charge  some  nominal 
account  and  thus  create  a  secret  reserve  (which,  of  course,  is  bad 
accounting,  for  the  purpose  of  accounting  is  not  to  hide  the  truth 
but  to  show  it).  If  these  earnings  are  assumed  to  be  perpetual, 
good  will  once  purchased  is  an  asset  forever;  and  no  reason  ap- 
pears for  depreciating  it.  As  a  matter  of  fact,  however,  it  is  not 
uncommonly  written  off  the  books  over  a  series  of  years,  largely 
on  the  theory  that  the  old  good  will  does  wear  out  and  new  good 
will  takes  its  place  —  it  is  certainly  true  that  the  old  would  not 
last  long  if  no  effort  were  made  to  create  new;  but  if  the  new 
maintains  or  replaces  the  old,  no  reason  except  conservatism 
(virtually  a  desire  for  a  secret  reserve)  exists  for  writing  off  Good 
Will. 

'  Trade  Marks.    Akin  to  good  will  is  the  right  to  a  trade  mark. 
Indeed  the  possession  of  a  trade  mark  may  be  one  of  the  elements 


THE  EFFECT  OF  INTEREST  ON  VALUES     369 

of  good  will.  Like  good  will,  however,  the  possession  of  a  trade 
mark  should  not  be  entered  as  an  asset  unless  it  has  been  pur- 
chased. The  value,  moreover,  is  very  hard  to  learn,  for  nothing 
can  tell  how  much  of  general  profits  comes  from  the  possession  of 
such  a  mark  and  how  much  comes  from  other  sources. 

Franchises.  Akin  to  good  will  are  also  franchises,  or  rights  to 
conduct  certain  businesses,  particularly  public-utility  services. 
If  the  franchise  is  perpetual,  its  value  depends  upon  the  earning 
capacity.  If  the  earning  capacity  is  no  greater  than  a  reasonable 
return  on  the  investment  of  property,  the  franchise  has  no  value 
(unless  for  some  extraneous  reason  not  connected  with  the  opera- 
tion of  the  property  as  an  entity) ;  but  if  it  assures  large  profits  in 
perpetuity,  it  has  a  value  equal  to  the  capitaHzed  value  of  the 
earnings  above  normal. 

Concessions.  Akin  to  franchises,  and  yet  of  a  type  so  different 
that  in  a  sense  we  come  now  to  a  new  field,  are  concessions  for  a 
fixed  period  of  time,  like  the  right  to  maintain  news-stands  in 
railroad  stations,  etc.  If  the  right  to  maintain  a  news-stand  will 
bring  $5,000  a  year  above  the  natural  rate  of  profits  on  the  capital 
invested,  the  value  of  that  concession  is  $5,000  a  year;  but  as  it 
would  always  be  given  for  a  limited  time  only,  its  value  would  not 
be  the  capitalized  value  of  an  income  of  $5,000  a  year.  The  price 
paid  would  depend  upon  the  duration  of  the  concession  and  upon 
the  time  of  payment.  If,  for  example,  the  concession  were  for  one 
year  and  the  payment  were  one  lump  sum  payable  in  advance, 
the  price  should  not  be  $5,000;  for  no  one  would  pay  $5,000  now 
for  the  privilege  of  getting  $5,000  by  the  end  of  the  year.  The 
purchaser  should  pay  in  advance  the  present  worth  of  what  is 
virtually  a  steady  stream  of  installments  that  will  come  to  a  total 
of  $5,000  at  the  end  of  the  year.  If  the  concession  is  for  two 
years,  and  payment  is  made  in  advance,  the  price  will  be  the 
present  worth  of  a  stream  that  will  come  to  a  total  of  $10,000  in 
two  years.  If,  however,  the  payments  are  to  be  made  monthly, 
we  should  find  a  series  of  monthly  payments  that  equal  in  value  a 
steady  stream  that  will  come  to  a  total  of  $10,000  in  two  years. 
In  practice  the  matter  is  not  worked  out  so  finely  as  this,  for  no 
one  knows  what  the  profits  are  going  to  be,  and  it  is  absurd  to 
work  out  to  a  high  degree  of  refinement  the  mathematical  end  of 


370  THE  FUNDAMENTALS  OF  ACCOUNTING 

the  problem  when  the  basis  figure  of  the  whole  thing  is  itself  prob- 
lematical. We  shaU  later  find  kinds  of  kindred  transactions, 
however,  in  which  the  basis  figure  itself  is  a  matter  of  contract 
and  therefore  known,  and  hence  the  calculation  may  be,  and  as  a 
matter  of  business  practice  actually  is,  very  fine.  The  discussion 
of  accounting  for  concessions  we  will  postpone  until  we  have  ob- 
served some  other  intangible  properties  of  somewhat  the  same 
type. 

Patents  and  Copyrights.  The  value  of  a  patent  and  of  a  copy- 
right will  be  determined  on  similar  considerations,  for  the  monop- 
oly privilege  which  each  confers  may  have  an  earning  capacity 
and  is  by  law  limited  to  a  term  of  years.  If  the  possession  of  a 
patent  or  a  copyright  enables  me  to  sell  at  a  higher  price  or  to  sell 
more  goods,  the  possession  is  worth  paying  for  as  a  single  sum,  or 
as  commuted  to  an  annual  or  a  monthly  charge,  or  as  a  royalty  of  a 
certain  sum  for  each  article  produced  and  sold  under  the  contract. 

Accounting  for  Concessions,  Patents,  Copyrights.  If  a  con- 
cession, a  patent,  or  a  copyright,  is  secured  under  terms  which 
call  for  a  periodic  payment,  either  fixed  or  on  a  unit-royalty  basis, 
the  accounting  is  simple.  It  means  simply  an  operating  charge. 
When,  however,  a  lump  sum  is  paid,  we  get  a  new  situation. 
This  lump  sum  represents  an  asset,  of  course,  for  it  estabUshes  a 
right  to  certain  privileges  that  are  expected  to  bring  a  return;  but 
it  is  not  a  perpetual  right,  as  good  will  and  franchises  may  be,  and 
consequently  it  cannot  remain  indefinitely  on  the  books.  It  dis- 
appears with  the  lapse  of  time.  In  order  to  see  what  to  do  with 
it,  we  must  see  just  what  it  is.  Suppose  a  patent  is  purchased  on 
the  supposition  that  the  ownership  of  that  patent  will  enable  the 
owner  to  make  $3,000  a  year  profit,  above  a  normal  return  on  his 
investment  in  manufacturing  and  selling  the  goods,  for  the  next 
ten  years.  The  price  of  the  patent,  supposing  it  is  fixed  on  this 
basis,  will  then  be,  on  a  5%  basis  for  the  use  of  money,  $23,165.21 
—  the  present  worth  of  an  annuity  of  $3,000  a  year  for  ten  years 
2it  5%.  When  purchased  at  that  price,  Patent  Right  may  be 
debited  as  an  asset  at  that  figure.  A  year  later,  however,  the 
right  is  no  longer  deemed  worth  that  figure,  for  it  is  now  estimated 
to  yield  a  profit  of  $3,000  for  nine  years  only;  and  the  present 
worth  of  an  annuity  of  $3,000  a  year  for  nine  years  is  only  $21,- 


THE  EFFECT  OF  INTEREST  ON  VALUES      37I 

323.47.  So  the  shrinkage  is  $1,841.74,  and  this  is  chargeable  as  a 
cost  of  the  business  of  producing  and  selling  the  patented  article. 
As  a  matter  of  fact,  moreover,  we  have  not  only  suffered  a  shrink- 
age of  our  patent  right  during  the  year,  but  have  also  lost  the  use 
of  our  money  paid  for  the  patent.  If  we  take  that  at  5%  (the 
rate  actually  used  in  determining  the  value  of  the  patent),  we 
shall  find  that  the  interest  on  the  original  $23,165.21  paid  for  the 
patent  is  $1,158.26.  If  now  we  add  together  the  shrinkage  in  the 
patent  right  and  the  interest  on  the  investment,  we  get  the  $3,000 
with  which  we  started  as  the  annual  estimated  yield  from  the 
patent,  proving  the  correctness  of  our  figures  —  proving,  that  is  to 
say,  that  the  price  paid  was  correct.  For  the  seller  of  the  patent, 
too,  the  price  is  right,  for  he  has  had  the  use  of  the  money  for  a 
year,  worth  $1,158.26,  and  the  portion  belonging  to  this  year  of 
the  $23,165.21  paid  to  him  is  $1,841.74,  or  a  total  of  $3,000,  which 
just  offsets  the  estimated  earning  capacity  for  one  year  of  the 
patent  which  he  surrendered.  If  we  deem  interest  on  the  money 
locked  up  in  the  patent  to  be  one  of  the  costs  of  using  the  patent, 
as  most  cost  accountants  do,  our  entry  at  the  end  of  the  year  will 
be  a  debit  to  Patent  Privileges,  $3,000,  and  a  credit  to  Patent 
Right,  $1,841.74,  and  to  Interest  Earned,  $1,158.26.  Whether 
the  interest  shall  be  taken  into  account  or  not  is  discussed  in  the 
next  chapter;  but  it  is  indisputable  that  operating  expenses  must 
be  debited  for  the  shrinkage  in  the  patent  right  and  that  Patent 
Right  must  be  credited.  This  same  principle  applies  to  Conces- 
sions, Copyrights,  and  any  other  similar  rights  which  have  been 
purchased  for  a  lump  sum  but  expire  beyond  the  current  earning 
period. 

Leaseholds.  What  has  just  been  discussed  in  connection  with 
patents  and  copyrights  would  apply  also  to  leaseholds  if  it  were 
customary  to  pay  in  advance  for  a  limited  number  of  years'  right 
of  tenancy.  Usually,  of  course,  a  person  desiring  tenancy  either 
buys  the  property  or  leases  it  for  a  periodic  rental.  In  fixing 
rental  on  a  lease,  of  course,  effort  is  made  to  fix  it  right  —  that 
is,  the  principle  of  bargaining  tends  on  the  whole  to  make  it 
right  for  the  life  of  the  lease.  Yet  it  often  happens  that  during  the 
life  of  a  lease  changes  occur  in  the  real  estate  market,  and  the 
property  becomes  more  or  less  valuable  than  it  was  deemed  to  be 


37^  THE  FUNDAMENTALS  OF  ACCOUNTING 

(even  allowing  for  the  future)  at  the  time  the  lease  was  made. 
The  property  may  become  either  too  good  or  too  poor  for  the  pur- 
pose for  which  it  has  been  used,  and  a  change  of  tenancy  may  be 
wise.  Suppose  the  lease  has  yet  ten  years  to  run  at  an  annual 
rental  of  $10,000,  but  because  of  changes  in  the  course  of  trade  the 
property  is  now  worth  $13,000  a  year.  Obviously  the  holder 
of  the  lease  has  in  his  possession  a  right  worth  $3,000  a  year  — 
the  right  to  use  at  a  cost  to  him  of  $10,000  what  has  an  earning 
capacity  of  $13,000.  This  right  has  then  a  value  equal  to  the 
present  worth  of  $3,000  a  year  for  ten  years  —  which  we  saw  in 
the  last  paragraph  to  be,  at  5%,  $23,165.21.  A  buyer  of  the 
lease  from  him  at  that  price  will  debit  Leasehold  for  that  sum. 
The  seller,  in  turn,  since  he  gets  this  as  a  pure  chance  gain  not 
connected  with  the  operations  of  his  business,  will  credit  Surplus, 
or,  preferably.  Capital  Surplus.  The  buyer,  on  the  other  hand, 
must  realize  that  this  leasehold  does  not  constitute  a  perpetual 
asset,  but  one  rapidly  disappearing.  In  the  first  year  of  his 
tenancy  he  will  have  three  items  to  consider  in  his  rental  — 
$10,000  to  be  paid  to  the  landlord  as  required  by  the  lease  which 
he  has  purchased,  $1,841.74  shrinkage  on  the  lease  (similar  to  the 
shrinkage  in  the  patent  right  as  shown  in  the  preceding  paragraph) , 
and  $1,158.26  interest  on  his  investment.  These  together  make 
$13,000,  the  fair  rental  charge.  The  next  year  the  rent  will  be 
$10,000,  the  shrinkage  in  the  leasehold  right  will  be  $1,933.83  (the 
present  worth  of  an  annuity  of  $3,000  for  eight  years  is  $19,389.64), 
and  the  interest  on  the  investment  will  be  $1,066.17  (less  than 
before,  because  a  part  of  the  investment  has  been  returned  in  the 
first  yearns  use  of  the  building  and  the  balance  of  investment  re- 
maining at  the  end  of  the  first  year  is  only  $21,323.47).  This 
again  gives  $13,000  total  rent. 

Bonds.  When  we  turn  to  bonds  we  find  future  realizations 
that  are  not  problematical  but  stipulated  by  contract.  A  bond  is 
a  promise  to  pay  two  things  —  a  certain  sum,  called  the  principal, 
at  a  date  named,  usually  rather  remote  (sometimes  in  as  few  as  five, 
and  sometimes  in  as  many  as  seventy-five  years),  and  interest 
periodically  until  the  principal  is  paid.  The  value  of  the  bond  is 
the  present  worth  of  those  two  things  —  the  present  worth  of  the 
principal  plus  the  present  worth  of  the  series  of  interest  payments. 


THE  EFFECT  OF  INTEREST  ON  VALUES      37J 

The  only  element  of  uncertainty  in  the  situation  is  the  rate  of 
interest  to  be  used  in  valuing  those  future  payments.  It  should 
be  noted  that  the  rate  of  interest  used  for  this  purpose  may  or  may 
not  be  the  same  as  the  rate  of  interest  *' nominated  in  the  bond" 
as  payable  until  the  principal  is  paid.  Suppose  a  railroad  issues 
bonds  in  denominations  of  $1,000,  payable  in  ten  years,  with 
interest  at  4^%.  This  means  that  the  road  promises  to  pay  for 
each  bond  $1,000  at  the  end  of  ten  years  and  interest  amounting 
to  $45  per  year  during  that  time.  If  the  credit  of  the  road  is  good, 
so  that  no  one  questions  its  abihty  and  willingness  to  pay  the 
principal  and  interest  (except  as  business  is  subject  always  to 
risks,  some  businesses  to  more  and  some  to  less  even  in  the  same 
general  line,  because  of  local  or  individual  conditions),  the  bonds 
will  be  desirable  just  in  proportion  as  the  interest  payable  on  the 
principal  of  the  bond  is  deemed  by  investors  satisfactory.  If  the 
conditions  of  risk  surrounding  the  issue  of  these  bonds,  or  the  road 
which  issues  them,  are  such  that  investors  think  the  bonds  ought 
to  pay  5%  interest  rather  than  4j%,  the  bonds  will  not  be  worth 
par,  but  if  investors  would  be  satisfied  with  4%,  the  bonds  will  be 
worth  a  premium.  The  reason,  moreover,  will  be  exactly  similar 
to  the  reason  that  gives  a  value  to  stocks,  good  will,  patents, 
leaseholds,  etc. ;  but  it  can  be  applied  more  exactly,  for  here  there  is 
only  one  element  of  uncertainty,  the  rate  of  interest  that  ought 
to  be  used  in  discounting  the  future  realizations,  whereas  in  the 
other  cases  not  only  that  rate  but  the  amount  to  be  realized  in  the 
future  was  problematical. 

Finding  the  Value  of  a  Bond.  It  is  obvious  that  if  the  rate  of 
interest  to  be  paid  by  the  bonds  is  what  investors  deem  a  fair 
rate,  the  bonds  will  be  worth  par:  for  until  the  principal  of  the 
bonds  is  paid  the  investor  gets  as  interest  what  he  thinks  is  a  fair 
rate  to  compensate  him  for  the  use  of  his  money  and  the  risk  he 
takes.  So  in  that  case  the  value  of  the  bond  is  automatically 
found.  For  the  sake  of  an  illustration  to  follow,  however,  let  us 
find  the  value  of  this  bond  by  the  method  of  valuing  the  future 
realizations  to  come  from  it,  thus: 

Present  worth  of  $1,000,  payable  in  10  years,  discounted  at  4^% . .  $643 .  93 
Present  worth  of  annuity  of  $45  for  10  years,  discounted  at  45%. .  356.07 
Present  worth  of  bond $1,000. 00 


374  THE  FUNDAMENTALS  OF  ACCOUNTING 

We  see  the  proof  of  our  statement  that  the  bond  is  worth  par: 
the  interest  for  the  ten  years  compensates  the  buyer  of  the  bond 
for  waiting  to  get  back  the  $i,ooo  which  he  pays  for  it.  Now  let 
us  suppose  that  the  interest  provided  by  the  terms  of  the  bond  is 
not  4§%,  or  $45  a  year,  but  4%,  or  $40,  and  sti)^  the  investor 
thinks  that  in  view  of  the  risks  involved  he  shoula  be  promised 
4§%  on  his  money.  We  saw  a  few  moments  ago  that  he  will  not 
pay  par  for  the  bond.  How  much  will  he  pay?  Thinking  that 
he  ought  to  have  4^%  on  his  investment,  he  will  pay  a  price  that 
will  yield  4J%,  and  will  pay  no  more;  that  is,  he  will  discount  the 
future  realizations  on  the  bond  at  4^%  interest  and  pay  what  they 
are  worth,  as  follows: 

Present  worth  of  $1,000,  payable  in  10  yrs.,  discounted  at  4^%  . .  .$643.93 
Present  worth  of  annuity  of  $40  for  10  yrs.,  discounted  at  4!%  . . .  316.51 
Present  worth  of  bond $960.44 

The  drop  in  value  is  due  to  the  fact  that  now  the  interest  pay- 
ments of  forty  dollars  are  not  adequate  to  compensate  the  buyer 
for  the  ten  years  that  he  has  to  wait  to  get  his  money  back  if  he 
pays  $1,000;  and  so  he  will  not  pay  $1,000  for  the  bond.  If,  on 
the  other  hand,  the  bond  were  to  pay  $50  a  year  interest,  or  5% 
on  the  face  value,  the  value  of  the  bond  would  be  above  par,  as 
shown  below. 

Present  worth  of  $1,000,  payable  in  10  yrs.f  discounted  at  4^%. .  $643.93 
Present  worth  of  annuity  of  $50  for  10  yrs.,  discounted  at  4^%. .  395.63 
Present  worth  of  bond $1,039. 56 

It  should  now  be  observed  that  the  premium,  or  the  amount  by 
which  the  bond  is  worth  more  than  par,  is  in  this  last  case  $39.56; 
but  the  discount,  or  the  amount  by  which  the  bond  is  worth  less 
than  par,  was  in  the  previous  case  also  $39.56  ($1,000— $960.44). 
Is  this  a  coincidence?  By  no  means.  This  is  a  case  exactly 
parallel  with  good  will,  franchises,  patent  rights,  etc.  If  this  bond 
will  pay  interest  higher  than  that  which  will  give  a  normal  return 
on  the  investment,  which  is  commonly  called  the  *' basis"  rate 
or  the  '^ yield,"  it  is  worth  a  premium:  if  it  pays  a  lower  inter- 
est, it  will  be  at  a  discoimt.  Let  us  work  this  out  by  methods 
analogous  to  the  method  used  in  the  other  cases.  When  the  bond 
pays  4%  (that  is,  $40  a  year)  and  the  fair  rate  would  be  4i%  (or 


THE  EFFECT  OF  INTEREST  ON  VALUES      375 

$45),  the  bond  is  paying  $5  a  year  less  for  ten  years  than  it  should 
pay.  The  present  worth  of  an  annuity  of  $5  a  year  for  ten  years 
is  $39.56  (one-tenth  of  the  present  worth  of  an  annuity  of  $50  as 
shown  in  the  last  table).  So  of  course  the  bond  is  at  a  discount  of 
$39.56.  When,  however,  the  bond  pays  $50  a  year  interest,  it 
pays  an  extra  $5  above  the  fair  rate,  and  hence  is  worth  a  pre- 
mium of  $39.56.  So  we  may  find  the  value  of  a  bond  by  either  of 
two  methods  —  (i)  the  present  worth  of  the  principal  plus  the 
present  worth  of  the  interest  payments,  as  we  did  at  first,  or  (2) 
the  present  worth  of  any  excess  interest  to  be  added  to  the  face  of 
the  bond,  or  the  present  worth  of  any  deficiency  of  interest  to  be 
subtracted  from  the  face  of  the  bond.  If  the  bond  pays  interest 
semi-annually,  and  the  basis  rate  is  to  be  taken  also  as  half  yearly, 
its  value  will  be  found  by  similar  methods,  except  that  instead  of 
discounting  at  4^%  for  ten  periods,  we  must  discount  at  2|%  for 
twenty  periods,  and  the  interest  will  be  only  half  as  much  for  each 
period.  The  value  of  the  bond  when  it  pays  4%  a  year  in  semi- 
annual installments  will  be  $960.09,  and  when  it  pays  5%  a  year 
in  semi-annual  installments  will  be  $1,039.91. 

Accounting  for  Bonds.  The  accounting  for  bonds  is  similar  to 
that  for  patent  rights,  etc.,  for  the  rights  covered  by  bonds  have  a 
limit  of  time  and  hence  expire.  We  saw  in  the  last  paragraph  that 
a  ten-year  bond  for  $1,000  paying  5%  interest  when  4^%  is 
deemed  a  fair  rate  by  investors  is  worth  a  premium  of  $39.56. 
The  buyer  when  he  buys  at  that  price  will  debit  Bonds  (specifying 
the  kind)  $1 ,039.56.  He  must  remember,  however,  that  the  bond 
will  not  continue  to  be  worth  $1,039.56.  The  premium  is  due  to 
the  fact  that  the  bond  will  pay  excess  interest  for  ten  years. 
When,  however,  one  year's  interest  has  been  paid,  the  claim  to  ex- 
cess interest  is  for  only  nine  years,  with  a  present  worth  of  $36.34. 
So  there  is  a  shrinkage  of  $3.22  in  the  value  of  the  bond.  Indeed, 
on  the  day  of  maturity  the  bond  will  pay  only  $1,000  (plus  interest 
for  that  year),  and  hence  between  purchase  and  maturity  the 
shrinkage  will  be  $39.56,  of  which  this  $3.22  is  one  year's  in- 
stallment. (The  installment  is  less  than  one-tenth,  for,  as  with  the 
sinking-fund  method  of  depreciation,  even  if  we  take  less  than  one- 
tenth  in  early  years  the  accumulations  of  interest  will  build  up  the 
ten-tenths  by  maturity.)    Let  us  test  this  in  a  simple  way.    The 


376  THE  FUNDAMENTALS  OF  ACCOUNTING 

bond  sells  for  $1,039.56  because  the  buyer  is  willing  to  lend  money 
at  4J%,  and  he  found  that  by  paying  $1,039.56  he  could  get  his 
money  back  and  net  4§%  interest.  Let  us  see  whether  he  does 
that  if  he  must  suffer  a  shrinkage  in  the  value  of  his  bond  of  $3.22 
in  the  first  year.  The  cash  interest  that  he  receives  is,  by  suppo- 
sition, $50.00  (or  5%  on  a  $1,000  par  value  of  the  bond).  If  he 
loses  $3.22  shrinkage  (this  year's  installment  of  the  $39.56  that 
will  not  come  back  when  the  bond  is  paid  off  as  $1,000),  his  net 
interest  earned  is  $46.78  ($50.00— $3.22).  What  ought  he  to 
have?  He  has  invested  $1 ,039.56,  and  expects  4^%  on  his  invest- 
ment, which  is  exactly  $46.78.  In  other  words,  he  has  paid  just 
enough  for  the  bond,  and  must  realize  that  out  of  each  year's  in- 
terest received  a  part  must  be  labeled  on  his  accounts  as  partial 
return  of  his  premium.  When  he  receives  his  interest,  therefore, 
he  will  debit  Cash  $50.00,  credit  Bonds  $3.22,  and  credit  Interest 
Earned  $46.78.  Continuing  this  process  for  the  ten  years,  at  the 
end  of  the  time  he  will  have  reduced  the  value  of  the  bonds  to 
$1,000,  which  of  course  he  will  then  receive  in  cash  if  the  bonds  are 
good,  and  will  have  credited  Interest  Earned  for  4^%  on  the 
money  invested.  If  the  bonds  had  been  bought  at  a  discount,  the 
converse  would  have  been  true:  the  bond  interest  would  always 
have  been  less  than  4^%  on  the  investment,  but  the  bonds  would 
be  daily  growing  more  valuable  as  the  day  of  maturity  (with  a 
value  of  $1,000  though  they  were  bought  at  $960.44)  approached. 
The  entry  for  the  first  year  would  debit  Cash  $40.00  (for  under 
this  supposition  only  4%  interest  on  the  face  value  was  to  be 
paid),  debit  Bonds  (for  the  increase  in  value)  $3.22,  and  credit 
Interest  Earned  $43.22  (which  is  4§%  on  the  investment  of 
$960.44). 

Tables  for  Bond  Values.  It  is  clear  that  when  one  buys  a  bond 
at  either  a  premium  or  a  discount  the  interest  received  on  the  bond 
is  more  or  less  than  the  interest  earned,  and  the  difference  between 
the  interest  received  and  the  interest  earned  is  the  decrease  or  in- 
crease in  the  value  of  the  bond  itself.  Tables  have  been  worked 
out  and  pubUshed  to  cover  the  value  of  bonds  of  different  terms, 
bearing  different  rates  of  interest,  and  at  different  basis  rates  — 
i.e.,  to  yield  different  rates  of  interest  on  the  investment.  The 
difference  between  the  value  of  a  bond  having  ten  years  to  run 


THE  EFFECT  OF  INTEREST  ON  VALUES      377 

and  the  value  when  it  has  nine  years  to  run  is  the  increase  or  de- 
crease in  the  value  of  the  bond  in  the  tenth  year  before  maturity. 
Yet  without  such  tables  one  can  find  the  value  for  each  year,  and 
hence  the  "accumulation"  of  value,  as  increase  is  called,  or 
*^ amortisation'^  of  value,  as  decrease  is  called.  Indeed,  this  is 
easily  done  by  any  of  three  methods.  We  have  already  found  the 
value  of  such  a  bond  by  two  methods  for  ten  years,  and  by  one  of 
these  for  nine.  We  could  similarly  find  the  value  for  each  of  the 
ten  years.  This,  however,  does  not  prove  our  figures,  and  it  is 
convenient  to  use  a  method  which  proves  as  we  go.  For  bonds  at 
a  premium  a  so-called  amortisation  table  accomplishes  this.  For 
every  year  it  does  what  we  did  in  the  last  paragraph,  shows  that 
the  bond  interest  minus  the  amortisation  is  equal  to  the  basis 
(fair)  interest  on  the  amount  still  in  the  investment.  In  the  table 
following,  the  first  column  shows  the  interest  paid  by  the  bond; 
the  second  column  shows  the  basis  rate  (the  rate  agreed  upon  as 
fair  for  this  sort  of  investment)  on  the  preceding  book  value  of  the 
bond  as  shown  by  the  table;  the  third  column  shows  the  difference 
between  the  first  column  and  the  second,  and  therefore  the  amount 
by  which  the  owner  of  the  bond  has  received  more  than  the  basis 
rate,  and  therefore  the  amount  actually  returned  to  him  of  the 
premium  paid  by  him  (and  it  was  this  extra  interest  that  induced 
him  to  pay  that  premium);  and  the  last  column  shows  the  re- 
maining value  of  the  bond  —  the  original  cost  less  what  the 
owner  has  already  got  back  as  extra  interest,  and  hence  what 
still  remains  invested  in  the  bond. 

Date  Bond  Interest    Basis  Interest    Amortisation    Book  Value 


Jan.  I 

5% 

4i% 

1920 

1,039.56 

1921 

50.00 

46.78 

3.22 

1,036.34 

1922 

50.00 

46.64 

3.36 

1,032.98 

1923 

50.00 

46.48 

3.52 

1,029.46 

1924 

50.00 

46.33 

3.67 

1,025.79 

1925 

50.00 

46.16 

3.84 

1,021.95 

1926 

50.00 

45.99 

4.01 

1,017.94 

1927 

50.00 

45.81 

4.19 

1,013.75 

1928 

50-00 

45.61 

4.39 

1,009.36 

1929 

50.00 

45.42 

4.58 

1,004.78 

1930 

50.00 

45.22 

4.78 

1,000.00 

500.00  460.44  39.56 


378  THE  FUNDAMENTALS  OF  ACCOUNTING 

The  totals  also  serve  by  way  of  proof.  The  total  bond  interest 
for  ten  years,  $500,  less  the  basis  interest  $460.44,  gives  the 
amortisation,  $39.56;  and  this  subtracted  from  the  original  price 
of  the  bond  gives  the  par  value.  Each  year's  entry,  therefore, 
debits  Cash  for  the  bond  interest,  credits  Interest  Earned  for 
the  basis  interest,  and  credits  Bonds  for  the  amortisation.  The 
$1,000  finally  paid  on  the  bond,  plus  the  amortisations  received, 
gives  the  total  originally  paid  for  the  bond,  or  $1,039.56,  and  in- 
terest each  year  at  4^%  on  the  amount  not  amortised  is  also  shown 
as  received.  The  figure  given  in  the  book- value  column  at  each 
date  is  the  value  of  the  bond  on  that  date  exclusive  of  the  interest 
due  on  that  day  (that  is,  it  is  the  value  of  all  future  payments  to  be 
made  on  the  bond,  both  principal  and  interest) ;  for  a  seller  of  a 
bond  would  not  ordinarily  when  selling  on  an  interest  date  sell  the 
interest  claim  due  on  that  day  (that  would  be  like  selling  money). 
The  accumulation  table,  the  converse  of  this,  follows.  The  only 
explanation  needed  is  a  reminder  that  since  now  the  owner  is  not 
collecting  full  fair  interest,  the  amount  of  deficient  interest  should 
be  compounded,  as  is  shown  by  the  calculation  of  the  basis  rate  on 
the  growing  book  value. 

Date  Basis  Rate       Bond  Rate    Accumulation      Book  Value 


Jan.  I 

aWo 

4% 

1920 

960.44 

1921 

43.22 

40.00 

3.22 

963.66 

1922 

4336 

40.00 

3.36 

967.02 

1923 

43.52 

40.00 

3.52 

970.54 

1924 

43.67 

40.00 

3.67 

974.21 

1925 

43.84 

40.00 

3.84 

978.05 

1926 

44.01 

40.00 

4.01 

982.06 

1927 

44.19 

40.00 

4.19 

986.25 

1928 

44.39 

40.00 

4.39 

990.64 

1929 

44.58 

40.00 

4.58 

995.22 

1930 

44.78 

40.00 

4.78 

1,000.00 

439.56         400.00        39.56 

The  Importance  of  Amortisation  and  Accumulation.  That  the 
disappearance  of  premium  and  of  discount  as  a  bond^proaches 
maturity  is  important  may  be  shown  by  two  simple  illustrations. 
'Suppose  a  will  provides  that  the  income  of  a  certain  estate  shall 
go  to  certain  individual  beneficiaries  during  their  lives  and  on 


THE  EFFECT  OF  INTEREST  ON  VALUES      379 

their  decease  shall  go  to  certain  charities.  Suppose  the  estate 
is  of  $100,000,  and  the  trustee  invests  it  in  bonds  which  he  buys 
at  125  —  that  is,  a  $1,000  bond  for  $1,250.  He  will  then  get 
$80,000  in  par  value  of  bonds.  Suppose  he  gives  all  the  interest  to 
the  individual  beneficiaries  and  when  the  bonds  come  due  collects 
the  $80,000  and  buys  some  more  at  133^.  He  will  get  $60,000 
worth  of  new  bonds.  Suppose  he  again  gives  all  the  interest  to 
the  individual  beneficiaries.  When  these  bonds  come  due  he  will 
have  only  $60,000  in  the  capital  of  the  estate,  though  the  estate 
was  originally  $100,000.  He  has  given  to  the  life  beneficiaries 
nearly  one-half  the  estate  that  belongs  to  the  charitable  organiza- 
tions. Let  us  now  reverse  the  case,  buy  bonds  at  a  discount,  and 
pay  no  attention  to  accumulation.  Suppose  bonds  are  bought 
at  80  for  the  estate.  The  par  value  purchased  will  be  $125,000; 
but  the  interest  will  be  low  —  else  the  bonds  could  not  be  bought 
at  80.  Suppose  the  life  beneficiaries  receive  the  bond  interest 
until  just  before  the  bonds  mature,  and  then  they  die.  The 
charitable  organizations  will  receive  $125,000  though  the  estate 
intended  for  them  was  only  $100,000:  the  trustee  has  robbed  the 
life  beneficiaries  of  $25,000.  The  details  of  handling  trust  estates 
are  complicated,  and  have  no  place  in  a  book  of  this  sort;  but  the 
importance  of  distinguishing  between  capital  and  income  is  fun- 
damental in  all  business. 

Profit  and  Loss  on  Bond  Sales.  Often  an  investor  thinks  he  has 
made  a  profit  on  bonds  when  he  has  really  suffered  a  loss,  or 
vice  versa.  Bonds  bought  at  a  discount  are,  imless  something 
extraneous  to  them  occurs,  bound  to  rise  in  value  with  the  ap- 
proach of  maturity.  That  rise  is  not  profit  to  the  holder  —  it  is 
mere  compensation  to  him  for  accepting  a  lower  rate  of  interest 
(perhaps  not  actually  low,  but  lower  than  the  natural  fair  rate 
where  such  risks  are  involved).  If,  then,  he  sells  his  bonds  think- 
ing that  he  has  made  a  profit,  and  the  price  at  which  he  sells  is  not 
so  much  above  his  buying  price  as  the  natural  accumulation  on  the 
bonds,  he  has  deceived  himseK.  He  needed  to  sell  at  more  than 
he  did  in  order  to  avoid  loss.  Conversely,  if  bonds  at  a  premium 
fall  in  the  market,  the  fall  may  be  due  to  the  inevitable  approach 
of  maturity  and  disappearance  of  premium.  To  suffer  that 
shrinkage  is  not  to  lose,  for  compensation  is  in  the  higher  interest 


380  THE  FUNDAMENTALS  OF  ACCOUNTING 

rate  while  the  bonds  are  held.  To  determine  profit  or  loss,  then, 
one  must  accumulate  or  amortise  the  bonds  to  the  day  of  sale, 
bringing  them  to  book  value  on  that  day,  and  then  enter  the 
difference  between  that  value  and  selling  price  to  the  appro- 
priate account  previously  discussed.  For  less  than  a  full  interest 
period  amortisation  and  accumulation  are  taken  at  the  propor- 
tional part  of  the  full  amount  for  the  period.  This  creates  for  the 
novice  a  danger  of  error  in  calculating  amortisation  or  accumu- 
lation for  the  remainder  of  that  period  (too  confusing  for  exam- 
ination in  a  book  of  this  sort):  suffice  it  to  say  that  splitting  a 
period  in  this  way  does  not  establish  a  new  period  for  the  com- 
pounding of  interest,  but  the  continuation  of  an  amortisation  or 
accumulation  table  is  made  by  taking  for  the  rest  of  the  split 
period  the  remaining  portion  of  the  figures  for  the  whole  period, 
and  then  going  on  with  a  straight  table  as  if  no  splitting  had 
occurred.  One  should  be  careful,  too,  not  to  credit  the  bond 
account  for  the  amount  of  the  sale,  unless  all  bonds  in  the  account 
are  sold;  for  if  that  is  done  and  a  profit  is  made,  the  credit  for  the 
profit  appears  to  reduce  the  value  of  the  bonds  remaining,  and  if 
a  loss  is  suffered  the  failure  to  take  out  of  the  account  so  much  as 
was  actually  taken  out  in  book  value  of  bonds  appears  to  raise  the 
value  of  what  remains.  The  bond  account  should  be  credited  for 
the  book  value  only  of  what  was  taken  out. 

Accounting  for  Issues  of  Bonds.  The  entries  for  issuers  of 
bonds  are  the  converse  of  those  for  purchasers.  When  a  corpora- 
tion issues  its  bonds  at  a  premium,  it  debits  Cash  for  the  amount 
received,  credits  Bonds  Issued  (distinguishing  kinds  if  more  than 
one  kind  is  issued)  for  the  face  of  the  bonds,  and  credits  Premium 
on  Bonds  Issued  for  the  premium.  This  premium  is  a  Hability: 
not  for  repayment  when  the  bonds  are  paid,  for  only  the  par  will 
be  paid,  but  for  continued  extra  interest  pa)anents  as  long  as  the 
bonds  remain  unpaid.  Obviously  each  year,  as  the  interest  is 
paid,  this  liability  is  in  part  met,  and  it  may  be  reduced.  Interest 
Charges  need  be  debited  only  for  the  basis  rate  on  the  bonds  (say 
4^%  on  par,  though  the  bonds  bear  5%),  and  Premium  on  Bonds 
may  be  debited  for  the  difference  between  that  and  the  cash  paid, 
reversing  the  entry  made  by  the  receiver  of  the  interest.  When  a 
company  issues  bonds  at  a  discount,  it  debits  Cash  for  the  amount 


THE  EFFECT  OF  INTEREST  ON  VALUES      38 1 

received,  debits  Discount  on  Bonds  Issued  for  the  discount,  and 
credits  Bonds  Issued  for  the  par  value.  This  Discount  on  Bonds 
Issued  represents  an  asset  —  the  right  to  keep  the  money  of 
lenders  without  paying  normal  interest  on  it.  The  company  pays 
for  that  asset,  however,  in  paying  at  the  maturity  of  the  bonds 
more  than  it  got  for  them  at  issue.  The  approach  of  maturity  de- 
stroys the  asset,  and  it  must  each  year  be  written  down  by  a  credit, 
which  is  accompanied  by  a  debit  to  Interest  Charges,  increasing 
the  latter  account  to  a  normal  interest  on  the  money  borrowed. 
Other  Bond  Considerations.  The  subject  of  investments  in- 
volves many  considerations  not  even  hinted  at  in  these  pages,  for 
many  complicated  financial  arrangements  are  often  involved, 
and  these  often  involve  mathematical  calculations  more  elaborate 
than  is  worth  while  here.  Such  are  bonds  bearing  two  rates  of 
interest,  one  after  the  other,  and  bonds  giving  the  issuer  the  privi- 
lege of  redemption  earlier  than  the  normal  maturity.  This  enables 
the  issuer  to  take  advantage  of  a  fall  in  the  market  rate  of  interest 
—  but  of  course  the  investor  appreciates  that  and  allows  for  it  in 
his  willingness  to  buy.  If  the  buyer  and  the  seller  are  agreed  as 
to  conditions,  they  will  fix  the  same  price  for  the  bond  —  for  the 
price  is  determinable  mathematically.  The  respect  in  which  peo- 
ple who  know  their  business  have  different  prices  in  mind  for  the 
same  bond  is  the  rate  of  interest  which  they  use  for  discounting 
future  realizations.  One  man  thinks  for  certain  risks  5%  is  fair, 
and  another  thinks  nothing  less  than  5§%  is  fair.  By  the  same 
kind  of  mathematical  calculation  they  inevitably  get  different 
results  for  the  fair  price  for  the  bond. 

QUESTIONS  AND  PROBLEMS 

1.  A  holds  the  lease  of  a  building  for  two  years,  rental  payable  $600  at 
the  end  of  each  half-year.  He  sublets  the  building  for  $1,440  per  year, 
payable  semi-annually  (at  the  same  time  that  his  payments  as  lease- 
holder are  due),  but  with  the  understanding  that  he  may  end  the  sub- 
tenancy at  will  at  the  end  of  any  six-months  period,  (a)  Assuming  that 
he  is  assiired  of  constant  subtenancy  if  he  desires  it,  would  he  make  a 
profit  or  a  loss  if  he  should  accept  an  offer  of  $400  for  the  leasehold 
privileges?    (b)  What  entry  should  he  make  on  his  books  if  he  sells? 

2.  An  author  contracted  with  a  publishing  house  to  publish  a  book.  The 
author  was  to  receive  a  minimum  royalty  of  $100  at  the  end  of  each  of 


382  THE  FUNDAMENTALS  OF  ACCOUNTING 

three  years,  and  in  addition  $.20  on  each  copy  sold  during  the  year  above 
500.    At  the  end  of  three  years  all  rights  of  the  author  were  to  cease. 

The  author  immediately  sold  his  royalty  rights  on  the  basis  of  his 
minimum  guarantee. 

Actually  700  copies  of  the  book  were  sold  in  the  first  year,  and  800 
in  both  the  second  and  the  third  year. 

Show  the  entries  on  the  books  of  both  the  purchaser  and  the  author 
for  all  the  transactions.    Interest  may  be  assumed  to  be  at  6%. 

3.  (a)  An  industrial  company  issues  $i,ocx5,ooo  of  4%  bonds  at  a  dis- 

count of  $53,700.    Should  the  discount  appear  on  its  balance  sheet? 
If  so,  how  and  where? 

(b)  A  year  later,  without  any  change  in  the  credit  of  the  company  or  in 
the  state  of  the  money  market,  the  acknowledged  proper  discount 
is  but  $51,116.    Explain  (without  attempting  to  prove  the  figures). 

(c)  How  will  this  change  affect  the  books  of  the  company?  Show  any 
entries  required  to  produce  the  effect. 

4.  Two  bonds  are  offered  you:  one  is  for  $1,000,  4%,  payable  in  two  years, 
offered  at  98,  and  you  think  5%  is  a  fair  basis;  and  the  other  is  for 
$1,000,  4^%,  payable  in  three  years,  offered  at  ioi§,  and  you  think  a 
4%  basis  fair.    Which  is  the  better  offer? 

5.  Fill  in  the  missmg  items  of  the  following  table,  and  tell  how  you  know 


vhsit  to  add. 

Bond  Interest 
$2,500 

Basis  Interest 

$2,028.84 

$471.16 

Booh  Value 
$101^1.94 

/Aiy. 

!!*.".*.*. 

6.  Fill  out  the  book-value  column  by  any  method,  but  show  all  the  figures 
you  use. 

Bond  Interest  Basis  Interest       Amortisation       Book  Value  Par  Valve 

1/1/17  •  •  •  •  •  -  •  •  $20,380. 78.        $20,000 


.  .   .       ....        •-••  ••••        ♦20,350.75, 

7/1/17       -^5(?^      $407.61  $92.39         ^^oi^'^A^  20,000 


ij'i-ll^  ....  ....  ....  ....  20,000 

ll^liZ       ^f?.  ....  ....  20,000 

1/1/ 19  X^'i .  ....  20,000.00  20,00D 

7.  A  business  holds  a  lease  on  property  worth  for  rental  purposes  $20,000 
a  year,  but  the  lease,  of  long  standing  and  with  three  years  yet  to  run, 
calls  for  a  rental  of  only  $15,000  annually.  The  company  has  not  that 
lease  on  its  books,  for  at  the  time  of  signature  the  rental  of  $15,000  was 
fair.  You  now,  considering  the  money  to  be  worth  6%,  buy  the  lease 
for  $13,365.06  in  cash. 

(a)  What  entry  should  the  selling  business  make  on  its  accounts  at  the 
time  of  sale? 

(b)  What  entry  should  you  make  for  the  purchase? 

(c)  Should  you  ever  make  any  other  entry  in  respect  to  the  lease? 
If  so,  when  and  what? 


THE  EFFECT  OF  INTEREST  ON  VALUES  383 

8.  (a)  Fill  in  the  missing  items  of  the  following  table: 

Basis  Interest          Bond  Interest            Accumulation  Book  Value  Par  Value 
$49,279.03  $5o,cxx> 

$985.58      $750.00       ^.^^.x*     v?47.^;w/ 


(b)  What  rate  of  interest  does  the  bond  bear,  and  what  is  the  basis  rate? 

(c)  Can  you  be  sure  of  these,  or  are  they  only  one  set  of  answers  out  of 
several  possible  sets  of  answers?    Could  the  bond  rate  be  3%;  6%? 

If  the  lease  mentioned  in  Problem  i  above  is  sold  for  $446.05,  what 
entry  or  entries  will  the  buyer  make  six  months  later  when  he  pays 
his  rent,  provided  he  occupies  the  property? 


CHAPTER  XXII 

FINDING  THE  COST  OF  PARTICULAR  PRODUCTS  OR  SERVICES 

The  Fundamental  Requirements.  At  the  bottom  of  all  attempt 
to  find  costs  must  lie  a  systematic  plan  for  the  content  of  accounts, 
so  that  one  may  know  that  things  of  the  same  kind  are  in  the 
same  account  and  that  nothing  else  is  there;  for  finding  costs  of 
particular  products  or  services  requires  gathering  together  all  the 
elements  of  cost  that  go  into  one  thing  and  excluding  all  costs  that 
do  not  go  into  it.  This  means,  then,  that  if  one  set  of  costs  goes 
into  certain  products  and  another  set  does  not,  those  two  sets 
must  not  be  combined  in  the  same  account  (else  the  account  must 
be  gone  over  and  cut  into  two  parts  before  the  desired  costs  can 
be  found).  Suppose,  for  example,  that  certain  products  require  a 
very  high  temperature  during  manufacture  (perhaps  in  a  long 
drying  process),  but  require  Httle  consumption  of  power  (for 
they  are  made  chiefly  by  hand),  but  certain  other  products  require 
little  artificial  heat  even  in  winter  and  require  much  power  (for 
they  are  made  on  heavy  machinery  in  a  long  process).  To  com- 
bine heat  and  power  into  one  account  would  make  it  impossible 
for  the  accountant  to  find  how  much  cost  should  be  carried  to  these 
products  with  respect  to  heat  and  power;  whereas  if  they  were 
separated  one  knowing  the  proportions  of  total  heat  chargeable  to 
one  product,  and  the  proportion  of  total  power  chargeable  to  the 
other,  could  directly  from  the  accounts  without  further  analysis 
attach  the  costs  to  the  ends  which  they  serve.  Whenever,  too, 
one  wishes  to  measure  cause  and  effect,  one  must  be  sure  that  the 
result  of  various  causes  be  not  carried  to  the  same  account,  else 
one  cannot  measure  the  effect  of  any  of  them.  Often,  to  be  sure, 
causes  are  so  thoroughly  intertwined  that  the  effect  cannot  be 
measured,  but  often,  on  the  other  hand,  they  can  be  so  differ- 
entiated. It  is  common,  for  example,  to  carry  light,  heat,  and 
power  to  one  account  —  presumably  because  they  all  originate  in 
fuel  consumption.  Yet  a  winter  of  warm,  dull,  damp  days  means 
a  low  charge  for  heat  but  a  high  charge  for  light;  but  a  winter  of 
clear,  cold,  windy  days  means  a  high  charge  for  heat  but  a  low 


FINDING  COST  OF  PRODUCTS  OR  SERVICES  385 

charge  for  light;  and  power  cost  is  hardly  appreciably  affected  by 
this  difference  in  weather.  To  combine  these  three  charges  into 
one  account  is  to  throw  away  the  opportunity  for  most  of  the 
statistical  information,  particularly  with  regard  to  economy,  that 
one  might  get  from  them. 

The  Resulting  Accounts.  The  result  of  these  requirements  is  in 
all  large  businesses  a  very  large  number  of  accounts  —  hundreds 
or  thousands  —  and  yet  by  the  use  of  labor-saving  devices  akin 
to  those  already  described  the  bookkeeping  labor  is  not  extreme, 
and  the  information  acquired  is  of  great  value  to  the  manager. 
Let  us  examine  a  Httle  more  fully  the  need  of  differentiated  ac- 
counts. Suppose  we  handle  many  kinds  of  raw  material.  Even 
though  all  go  into  the  same  product  and  always  in  the  same  pro- 
portions, we  should  keep  an  account  for  each,  so  that  we  may 
measure  the  effect  of  a  change  in  price  of  each  upon  our  total  cost 
for  raw  material,  and  especially  so  that  we  may  have  a  check  on 
wastefulness  or  theft  (for  an  increase  in  cost  out  of  ratio  to  the 
increase  in  price  and  to  the  increase  in  production  would  mean 
loss  somewhere).  Suppose  we  make  one  uniform  product,  but  sell 
It  in  different  ways  —  in  bulk,  in  cheap  packages,  in  attractive 
packages.  Not  only  the  cost  of  packages  and  the  labor  of  packing 
should  be  distinguished,  but  also  the  cost  of  the  different  t)^es 
of  packages  and  the  different  labor  costs  involved;  otherwise  we 
cannot  judge  the  economy  with  which  each  kind  of  packing  is 
done,  nor  can  we  judge  the  comparative  profit  of  each  class  of 
sale.  This  last,  moreover,  requires  that  we  keep  a  separate  sales 
account  for  each  class  of  sale  —  else  we  shall  have  nothing  with 
which  to  compare  the  costs  of  each  class  of  product.  Suppose  we 
manufacture  two  products  which  up  to  a  certain  point  follow 
identical  processes  but  then  separate  so  that  each  goes  its  own 
course.  Separate  accounts  would  be  kept  for  all  the  elements  of 
the  common  cost,  so  that  economy  could  be  watched,  and  then  a 
clearing  account  would  bring  together  all  the  common  costs  of 
the  two  products  up  to  that  point.  These  costs  would  then  be 
divided  between  the  two  products  on  an  equitable  basis  (de- 
pending on  circumstances),  and  would  be  carried  to  an  account 
for  each  product.  The  later  costs  lor  each  would  be  kept  not  only 
separate  for  the  two  products  but  analyzed  by  elements^  so  that 


386  THE  FUNDAMENTALS  OF  ACCOUNTING 

each  element  of  cost  could  be  watched;  and  then  the  individual 
costs  for  each  product  would  be  added  to  each  product's  share  of 
the  common  costs,  and  the  final  cost  for  each  would  be  then  avail- 
able. These  illustrations,  merely  typical,  serve  to  suggest  why  in 
the  pages  following  so  much  emphasis  is  laid  on  subdivisions  of 
accounts. 

Types  of  Cost  Finding.  Two  types  of  method,  adapted  to 
varying  circumstances,  suggest  themselves:  finding  the  cost  of  one 
individual  article  of  product,  from  elements  of  cost  traced  through 
the  whole  productive  process;  and  finding  the  average  cost  of 
groups  of  products  and  attaching  that  average  cost  to  each  article. 
Usually  the  first  of  these  is  impracticable,  even  when  desirable, 
for  the  reason  that  few  costs  are  incurred  for  one  individual  article 
of  product  alone.  Indeed,  we  may  say  that  no  individual  article 
of  product  is  in  ordinary  business  the  result  of  costs  incurred 
exclusively  for  its  production.  Though  the  cost  for  raw  material 
may  and  usually  does  go  exclusively  to  one  individual  article,  and 
though  much  of  the  labor  may  also  be  exclusive,  the  costs  for 
rent,  insurance,  taxes,  stationery,  power,  depreciation,  and  innu- 
merable other  things,  are  incurred  jointly  for  many  products,  and 
it  is  virtually  impossible  to  say  absolutely  how  much  of  any  of 
them  is  chargeable  to  one  individual  article  of  product.  Even  in 
construction  work  with  one  Job  done  at  a  time,  the  equipment 
used  is  almost  sure  to  be  shared  with  other  jobs,  and  the  general 
administration  is  common  to  many.  We  may  as  well  give  up  at 
the  start,  then,  any  attempt  to  find  absolutely  independent  costs 
of  individual  articles  except  in  instances  so  rare  that  they  are 
virtually  neghgible.  This  is  not  the  same  as  saying,  however, 
that  only  joint  or  average  costs  are  worth  finding.  In  many 
businesses  it  is  desirable,  if  not  actually  necessary,  to  find  indi- 
vidual costs  as  far  as  they  can  be  found  and  then  fall  back  on 
average  costs  for  those  elements,  to  be  added  to  the  individual 
costs,  which  can  be  found  only  as  averages  because  they  are 
always  joint. 

Finding  Average  Costs.  The  method  of  finding  average  costs 
is  to  divide  the  total  cost  in  question  by  the  number  of  units  of 
product  and  thus  get  the  cost  per  unit,  or  to  divide  the  cost  by 
some  other  cost  and  get  a  percentage  to  be  added  to  other  cost. 


FINDING  COST  OF  PRODUCTS  OR  SERVICES         387 

If,  for  example,  a  mill  is  producing  only  one  kind  of  flour,  the 
total  cost  of  all  product  divided  by  the  units  of  product,  pounds, 
or  tons,  gives  the  cost  per  pound  or  per  ton;  but  though  it  may 
be  true  that  a  particular  ton  cost  more  or  less  (because  of  inef- 
ficiency, waste,  or  what  not),  that  ton  is  not  now  distinguishable 
and  the  fact  is  neghgible,  for  some  other  ton  must  have  cost  less. 
If,  again,  we  wish  to  find  the  cost  of  a  specially  decorated  set  of 
furniture  and  this  set  is  identical  with  other  sets  except  for  its 
added  decoration,  we  can  find  its  cost  by  dividing  the  total  cost 
(exclusive  of  decoration)  of  all  sets  by  the  number  of  sets  and  then 
adding  the  cost  of  decoration  of  this  particular  set.  If,  finally,  we 
wish  to  find  the  cost  of  a  particular  article  manufactured  and  sold 
and  paid  for,  and  have  already  found  the  cost  manufactured  and 
sold,  we  will  divide  the  sum  of  the  cost  of  all  collections  and  the 
loss  from  all  bad  debts  by  the  sum  of  manufacturing  and  selling 
costs  of  all  product,  to  find  the  percentage  of  collection  cost  and 
loss,  and  then  add  this  percentage  to  the  cost  of  manufacture 
and  sale  of  this  individual  article.  This  assumes,  cf  course,  that 
the  cost  of  collection,  including  loss  from  bad  debts,  will  be  the 
same  for  this  individual  article  as  the  average  of  others;  but  it 
almost  certainly  will  run  higher  or  lower  (for  if  the  bill  is  paid 
there  will  be  no  loss  from  bad  debt,  and  if  it  is  not  paid  all  will  be 
lost);  and  yet  since  the  business  is  run  not  for  this  particular 
article  but  for  many  articles,  this  article  must  bear  its  share  of 
many  such  costs. 

The  Source  of  Average  Costs.  Cost  figures  may  of  course  be 
kept  as  purely  statistical,  without  other  connection  with  the  books 
than  common  origin  with  book  figures;  but  errors  in  statistical  fig- 
ures are  quite  as  easy  to  make  as  errors  on  the  books,  and,  sub- 
ject to  no  test  of  error  through  anything  corresponding  with  the 
trial  balance,  they  are  more  likely  to  carry  undiscovered  error 
than  accounting  figures.  For  this  reason  it  is  desirable  that  cost 
figures  be  incorporated  in  the  books  through  clearing  and  con- 
trolHng  accounts.  By  the  use  of  labor-saving  devices,  this  may 
be  accomplished  with  little  labor  and  with  reasonable  assurance 
that  under  proper  accounting  methods  omissions  and  duplications 
have  not  been  made.  When  cost  figures  are  tied  up  with  financial 
figures  on  the  books,  average  costs  are  found  commonly  directly 


388 


THE  FUNDAMENTALS  OF  ACCOUNTING 


from  the  books  by  dividing  the  costs,  as  shown  by  ledger  accounts, 
by  the  product,  thus  getting  average  costs  per  unit  —  whether 
those  average  costs  are  costs  for  single  elements  of  total  cost,  are 
combinations  of  elements  into  a  group  or  sub-total  cost,  or  are 
final  costs.  If,  for  example,  we  manufacture  four  classes  of 
articles,  and  use  twelve  processes,  but  different  classes  of  articles 
go  through  different  processes,  we  can  so  arrange  our  ledger  ac- 
counts as  to  furnish  average  costs  for  each  class.  Suppose  the 
processes  for  each  class  of  articles  are  as  tabulated  below,  showing 
by  crosses  in  the  column  for  each  class  of  article  what  processes 
each  goes  through  (the  line  of  the  table  indicating  the  process) ; 
and  suppose  the  cost  for  each  process  is  the  same  whichever  class 
of  article  passes  through  it. 


Process 

Class  A 

Class  B 

Class  C 

Class  D 

I 

X 

X 

X 

2 

X 

X 

3 

X 

X 

X 

X 

4 

X 

X 

X 

5 

X 

X 

6 

X 

7 

X 

X 

X 

8 

X 

X 

X 

X 

9 

X 

lO 

X 

II 

X 

12 

X 

X 

X 

X 

For  each  process  the  costs,  of  whatever  nature,  will  already  have 
been  gathered  to  the  clearing  account  for  the  process,  by  methods 
to  be  discussed  later.  For  each  class  of  goods,  moreover,  statisti- 
cal records  will  be  kept  showing  the  number  of  articles  going 
through  each  process.  Let  us  now  assume  certain  costs  for  each 
process  and  a  certain  number  of  articles  of  each  class,  find  the 
cost  per  unit  for  all  classes  for  each  process,  on  the  assumptions  of 
the  table  above,  and  find  the  unit  cost  of  each  article.  It  is  all 
done  simply  in  the  table  below.  The  cost  of  each  process  is  found 
from  the  books;  the  total  of  the  units  passing  through  each 
process  is  found  from  the  records  of  production;  the  cost  per  unit 
is  derived  by  division;  the  number  of  units  of  each  class  is  taken 


FINDING  COST  OF  PRODUCTS  OR  SERVICES        389 

from  the  records  of  production;  and  of  course  charge  is  made  to 
each  class  of  product  for  only  those  processes  which  that  class 
of  product  passes  through. 


Process 

Class  A 

2000  Units 

cost  each 

Class  B 
1000  Units 
cost  each 

Class  C 

Sooo  Units 

cost  each 

Class  D 

# 

Cost 

Total  Units 

Cost  per 
Unit 

3000  Units 
cost  each 

I 

$4,000 

8,000 

•50 

.50 

•SO 

•SO 

2 

6,000 

4,000 

I   50 

. 

I. SO 

I 

50 

3 

5,500 

11,000 

•SO 

SO 

•SO 

•SO 

50 

4 

9,000 

9,000 

1. 00 

. 

1. 00 

1. 00 

I 

00 

5 

.      300 

3,000 

.10 

10 

.10 

6 

400 

2,000 

.20 

20 

. 

7 

2.250 

9,000 

.25 

. 

•25 

•25 

25 

8 

1,100 

11,000 

.10 

10 

.10 

.10 

10 

9 

600 

3,000 

.20 

20 

10 

1,500 

5,000 

.30 

. 

.30 

. 

II 

2,000 

1,000 

2.00 

. 

2.00 

. 

12 

16,500 

11,000 

1.50 

I 

50 

1.50 

1.50 

I 

50 

Total  $49,150 

$2 

90 

$7.45 

$4.15 

$5 

05 

Proof:  Total  cost  of  all  processes  $49,150 

Cost  of  Class  A,  2000  @  2 .90  $5,800 

B,  1000  ©7.45  7,450 

C,  5000  ©4.15  20,750 

D,  3000  ©5.05  15,150         49,^50 

It  is  now  a  simple  matter  to  estabKsh  a  clearing  account  for  the 
gathering  of  these  costs  of  processes,  $49,150,  and  distribute  them 
to  the  accounts  for  the  goods  produced.  The  advantage  of  mak- 
ing the  distribution  on  the  books  is  that  when  we  get  through 
closing  our  books  we  know  whether  anything  has  got  into  this 
table  erroneously  or  has  been  omitted,  for  we  shall  either  still  find 
on  our  books  some  account  that  should  be  closed,  or  find  our  books 
out  of  balance. 

Finding  Special  Costs.  It  is  obvious  that  costs  of  articles  made 
in  small  quantities  or  individually  cannot  be  found  from  the 
ledger  in  the  way  mentioned  in  the  preceding  paragraph,  for  that 
would  involve  a  ledger  accoimt  with  each  special  cost  of  each 
special  job.  This  is  not  feasible.  What  is  done,  therefore,  is  to 
keep  what  in  effect  are  controlling  accounts  for  the  special  costs  of 
special  jobs  and  make  record  on  cost  sheets  (virtually  subordinate 
ledger  pages)  of  the  particular  share  of  such  total  special  costs 
chargeable  to  each  job.    If  several  articles  of  a  kind  are  made. 


390  THE  FUNDAMENTALS  OF  ACCOUNTING 

average  cost  will  probably  be  found  rather  than  individual  cost; 
but  unless  the  number  is  large  enough  to  make  worth  while  the 
setting  up  of  a  special  account  for  the  special  cost  of  the  lot,  the 
whole  lot  will  be  treated  as  one  article  (that  is,  it  will  be  given  a 
cost  sheet  for  the  lot  —  a  subordinate-ledger  account  rather  than 
a  general-ledger  account),  and  all  costs  of  the  lot  will  be  posted 
to  that  sheet  and  then  the  total  will  be  divided  by  the  number  of 
articles  in  the  lot  to  find  the  average  cost  for  each. 

The  Ultimate  Cost  Account.  The  final  accumulation  of  costs 
in  one  or  more  clearing  accounts  will  depend  upon  the  business 
and  the  kind  of  information  desired.  We  assumed  a  moment  ago 
that  the  costs  would  be  carried  to  separate  accounts  for  classes  of 
product.  When  the  number  of  classes  is  small,  that  is  probably 
desirable.  When,  on  the  other  hand,  products  are  numerous, 
varying  from  month  to  month,  and  particularly  when  they  are 
made  to  special  specification  and  not  to  standard  order,  it  is  only 
burdensome  to  estabhsh  ledger  accounts  for  each  kind  of  product. 
The  usual  practice  is  to  have  one  account  for  all  product  and  keep 
subordinate  accounts  for  classes  of  product  of  which  many  are 
made  of  a  kind,  for  lots  of  which  few  of  a  kind  are  made,  and  for 
individual  articles.  By  the  use  of  clearing  accounts,  however,  as 
we  have  already  seen,  much  detailed  information  may  be  kept 
along  the  way  and  yet  the  total  may  be  shown  on  the  books  in  a 
summary  account.  The  method  of  securing  such  detailed  in- 
formation, of  combining  it  into  groups  of  costs,  and  of  finally  dis- 
tributing it  over  products  or  services,  may  now  briefly  engage  our 
attention. 

Direct  and  Indirect  Costs.  Wherever  more  than  one  kind  of 
product  is  made,  it  is  obvious  that  the  costs  group  themselves 
naturally  into  two  classes:  direct,  those  which  are  incurred  for  one 
kind  of  product  only;  and  indirect,  or  joint,  which  are  incurred 
for  two  or  more  kinds  or  even  for  all  the  kinds.  The  direct  costs 
can  be  easily  charged  to  the  product  for  which  they  were  incurred 
—  provided  that  either  such  costs  are  kept  in  separate  ledger  ac- 
counts for  each,  or  memorandum  record  is  kept  daily  of  those 
costs  out  of  the  total  which  should  be  charged  to  the  particular 
groups  of  product.  The  indirect  costs,  on  the  other  hand,  are  not 
easily  charged  to  product,  for  usually  there  is  no  exact  method  of 


FINDING  COST  OF  PRODUCTS  OR  SERVICES         39I 

splitting  these  joint  costs  and  knowing  just  how  much  of  the  total 
is  really  chargeable  to  any  product  or  group  of  products.  The 
direct  costs  are  usually  at  least  two  in  number,  direct  material  and 
direct  wages,  commonly  together  called  "prime  costs,"  and  th^ 
indirect  costs  are  usually  almost  multitudinous,  like  indirect 
wages  (for  superintendence,  clerical  work,  janitor  service,  etc.), 
supplies  used  (in  the  storehouse,  in  the  factory,  in  the  office,  etc.), 
insurance,  taxes,  maintenance  of  buildings  and  of  machinery,  etc., 
etc.  Without  going  into  details,  we  will  examine  the  method  of 
finding  the  charge  to  product  for  each  of  these  types  of  cost. 

Direct  Labor.  If  only  one  type  of  product  is  made  and  only 
one  type  of  service  is  rendered,  all  labor  devoted  directly  to  pro- 
duction or  service  should  be  charged  to  an  account  separate  from 
other  labor,  so  that  the  total  charge  for  direct  labor  may  be  com- 
pared with  the  output.  This  charge  can  usually  be  found  di- 
rectly from  the  payroll.  If,  on  the  other  hand,  several  products 
or  services  are  provided,  a  wages  account  for  each  is  likely  to  be 
undesirable,  and  hence  analysis  must  be  made  not  only  of  the 
payroll  but  of  individual  items  on  the  payroll.  This  is  accom- 
plished best,  usually,  by  time  slips,  on  which  for  each  employee 
engaged  in  direct  production  is  a  daily  or  weekly  sheet  showing 
how  much  of  his  time  and  wages  have  been  devoted  to  each  kind 
of  production.  A  summary  of  these  sheets  gives  the  basis  for  a 
bookkeeping  entry  debiting  the  various  cost  accounts  (Process 
#1,  or  Special  Costs,  or  Goods-in-Process,  or  whatever  the  par- 
ticular method  may  call  for)  and  crediting  Wages.  A  posting  of 
the  item  from  the  time  sKp  to  the  cost  sheet  for  the  individual 
product,  or  for  the  lot,  gives  the  cost  in  detail,  where  that  is  re- 
quired, to  agree  with  the  controlling  account  (e.g.,  Special  Costs, 
or  Goods-in-Process).  The  payment  of  wages  is  debited  to 
Wages;  and  then  Wages  gives  the  statistics  of  wages,  but  the  cost 
has  been  passed  on  to  a  group  account.  A  credit  balance  on 
Wages  shows  a  liability  for  wages. 

Direct  Material.  A  well  organized  factory  or  service  station 
will  require  requisition  slips  for  all  material  taken  from  the  store- 
room —  as  a  protection  against  waste  and  thievery.  These  slips 
may  well  be  used  as  a  record  of  charges  for  material  (after  correc- 
tion for  materials  returned).    They  are  easily  summarized;  then 


392  THE  FUNDAMENTALS  OF  ACCOUNTING 

prices  are  attached;  and  an  entry  debiting  the  various  cost  ac- 
counts and  crediting  Raw  Material  (which  represents  stores  in 
the  storeroom)  is  made.  If  individual  or  lot  costs  are  desired,  an 
entry  is  made  to  the  cost  sheet  (a  virtual  subordinate  ledger)  as 
well  as  to  the  controlling  account. 

Other  Direct  Costs.  Occasionally  other  direct  costs  are  in- 
volved, such  as  special  freight,  special  insurance  in  case  of  extra 
risk,  outside  purchases  or  fees;  and  these  will  be  handled  in  the 
same  way  as  direct  wages  and  material  —  including  entry  on  cost 
sheets  if  subordinate  ledger  accounts  are  kept. 

Burden  Costs.  If  all  direct  charges  are  now  taken  care  of, 
the  task  of  distributing  joint  costs,  commonly  called  "burden," 
or  "overhead, ''  must  be  undertaken.  The  very  essence  of  these 
costs  is  that  because  they  are  joint,  there  is  no  known  absolutely 
right  way  of  dividing  them.  To  take  a  simple  illustration:  we 
need  an  engineer  and  a  fireman,  perhaps,  to  run  our  power  plant; 
increasing  our  output  of  certain  articles  calls  for  an  increase  of 
10%  in  the  power  produced  by  our  power  plant;  this  increase  in 
power  may  not  necessitate  more  help  in  the  power  house;  and  yet 
if  the  fireman  is  already  working  at  full  capacity  the  increase  will 
necessitate  a  new  man.  Is  it  true,  then,  in  case  no  new  man  is 
hired,  that  no  additional  charge  for  power  wages  should  be  made 
to  the  articles  of  which  production  is  increased  (because  the  cost 
is  not  increased),  and  in  case  a  new  man  is  employed  that  all  the 
wage  cost  of  the  new  man  should  be  charged  to  the  additional 
articles  produced?  There  is  always  something  to  be  said  on  the 
other  side.  Most  divisions  of  joint  cost  are  more  or  less  arbitrary 
—  though  they  may  have  so  much  sound  sense  behind  them  that 
for  practical  purposes  they  are  satisfactory.  The  task  of  dis- 
tribution of  burden  is  to  make  charges  as  fair  as  it  is  possible  to 
make  them  without  making  the  labor  of  distribution  unneces- 
sarily great  and  therefore  prohibitively  expensive. 

The  Importance  of  Fair  Distribution  of  Burden.  Though  it  is 
true  that  distribution  of  joint  costs  is  usually  more  or  less  arbi- 
trary, because  the  very  nature  of  them  makes  perfect  distribution 
impossible,  there  is  always  a  way  to  approximate  a  correct  dis- 
tribution, and  a  distribution  based  on  a  reasonable  approximation 
is  far  better  than  one  wholly  arbitrary.     Every  joint  cost  has 


FINDING  COST  OF  PRODUCTS  OR  SERVICES  393 

some  relation  to  the  product,  and  virtually  every  product  has  in  it 
some  (usually  much)  joint  cost.  If,  then,  the  Joint  costs  are 
analyzed,  so  that  the  relation  of  each  to  the  various  articles  of 
product  is  found,  and  then  each  joint  cost  is  distributed  over  the 
product  with  regard  to  such  relation,  the  distribution,  though 
more  or  less  arbitrary  at  best,  is  far  more  nearly  fair  than  one 
which  is  not  based  on  analysis  of  burden  but  distributes  all  bur- 
den over  all  product  in  blanket  form  regardless  of  what  analysis 
might  show.  If  as  a  consequence  of  arbitrary  distribution  the 
cost  of  certain  products  or  services  is  reported  to  be  high  and  of 
others  to  be  low,  whereas  distribution  on  an  analyzed  basis  would 
reverse  this,  the  neglect  of  analysis  may  be  serious.  The  business 
may  be  selling  largely  at  a  low  price  the  product  shown  by  its  cost 
accounting  to  be  low,  and  may  be  selling  very  Httle  of  the  product 
shown  as  of  high  cost,  whereas,  in  reahty,  it  will  be  selling  at  a  low 
price  what  really  costs  it  much  (and  that  may  be  the  reason  for 
sales),  but  it  cannot  recoup  itself  by  selling  at  a  high  price  what 
really  costs  it  little:  the  bad  accounting  has  led  the  manager  to 
make  prices  that  create  a  demand  for  goods  on  which  loss  is  suf- 
fered and  destroy  demand  for  goods  on  which  profit  would  be 
made  if  the  goods  could  be  sold  at  the  price  used.  Distribution 
of  burden,  then,  should  be  as  fair  as  feasible;  and  sometimes  it 
constitutes  so  large  a  part  of  the  total  cost,  seventy-five  per 
centum,  for  example,  that  careless  distribution  seriously  disturbs 
the  value  of  cost  figures. 

General  Methods  of  Distributing  Burden  Costs.  As  we  have 
already  observed,  burden  may  be  distributed  either  as  a  blanket 
charge,  on  the  same  basis  for  all  product,  or  it  may  be  analyzed 
and  then  be  distributed  piecemeal,  so  to  speak,  some  parts  in  one 
way  and  some  in  another.  Indeed,  the  burden  may  be  analyzed 
and  the  result  of  the  analysis  may  lead  to  the  conclusion  that  a 
blanket  method  (distributing  all  burden  on  all  production  on  the 
same  basis)  is  satisfactory.  Three  forms  of  blanket  distribution 
are  common:  total  burden  distributed  to  the  various  divisions  of 
product  in  the  ratio  of  (i)  the  direct  labor  hours  in  each  division  of 
product  to  the  total  direct  labor  hours  of  all  product;  (2)  the  di- 
rect wages  in  each  division  of  product  to  the  total  direct  wages  of 
all  product;  (3)  the  smn  of  direct  wages  and  raw  material  in  each 


394  THE  FUNDAMENTALS  OF  ACCOUNTING 

division  of  product  to  the  total  direct  wages  and  raw  material  in 
all  product.  Other  blanket  bases  are  possible  and  in  use,  but 
these  are  common  and  typical.  The  piecemeal  methods  of  dis- 
tribution are  many,  but  though  all  distribute  different  portions  of 
burden  on  different  bases,  as  indicated  by  analysis  of  burden,  all 
combine  into  one  basis  as  many  kinds  of  burden  as  possible,  so 
that  the  labor  of  distribution  will  be  reduced  to  a  minimum.  We 
will  first  observe  the  blanket  methods. 

Distribution  of  Burden  on  Labor  Hours.  Mathematically  the 
distribution  of  burden  on  labor  hours  is  easily  made.  If  the  total 
direct  labor  hours  of  a  factory  are  for  the  year  1,000,000,  and  the 
hours  on  a  lot  of  goods  are  10,000,  one  one-hundredth  of  all  the 
hours  were  spent  on  that  lot  of  goods.  Under  this  method  of  dis- 
tribution of  burden,  then,  one  one-hundredth  of  the  total  burden 
is  chargeable  to  this  lot  of  goods.  More  directly,  if  the  total  bur- 
den is  $400,000,  the  burden  rate  is  forty  cents  an  hour  ($400,000 
divided  by  1,000,000),  and  the  charge  to  this  lot  of  goods  for  bur- 
den is  $4,000.  Whether  this  is  sensible  or  not  depends  wholly  on 
the  circumstances  of  the  case.  Our  burden  charges  consist  of  all 
sorts  of  things,  such  as  heat,  light,  depreciation  of  buildings  and 
of  machinery,  clerical  service,  and  bookkeeping.  If  some  product 
is  made  by  machinery  and  some  by  hand,  the  first  involves  power 
and  maintenance  of  machinery,  and  the  other  involves  neither;  so 
that  a  blanket  rate  based  on  hours  will  not  serve.  If  some  prod- 
uct requires  a  great  deal  of  room  for  manipulation,  as  in  curing  or 
drying,  and  other  product  requires  little,  one  involves  large  cost 
for  rent  and  heat,  and  the  other  little;  and  a  blanket  rate  based  on 
hours  gives  wrong  figures.  If,  on  the  other  hand,  the  product  is 
so  nearly  of  the  same  type  that  every  hour  of  labor  going  into  any 
product  involves  approximately  the  same  cost  for  the  building, 
for  power,  for  machinery,  for  supervision,  for  clerical  service,  and 
for  a  hundred  other  things,  as  every  other  hour  on  any  other 
product,  this  is  a  satisfactory  basis. 

Distribution  of  Burden  on  Wages.  The  substitution  of  wages 
for  labor  hours  is  likely  to  simplify  the  task  of  burden  distribution, 
for  wages  are  more  likely  to  be  known,  for  other  purposes  than 
cost  accounting,  than  are  hours;  but  the  number  of  cases  in  which 
burden  can  be  distributed  adequately  on  a  wage  basis  is  much 


FINDING  COST  OF  PRODUCTS  OR  SERVICES  39S 

smaller.  The  cost  of  housing  a  factory  is  appreciable  in  most 
businesses;  but  a  man  paid  ten  dollars  a  day  does  not  require 
twice  as  much  space  or  light  or  heat  as  one  paid  five  dollars  a  day, 
nor  five  times  as  much  as  a  boy  paid  two  dollars  a  day  —  unless, 
indeed,  he  is  operating  a  machine  that  requires  the  extra  space,  or 
is  handling  material  that  is  bulky.  As  a  matter  of  fact,  these  last 
suppositions  are  not  true  of  most  factories,  for  it  is  quite  as  likely 
to  be  the  employees  on  the  lower  wages  who  are  running  the  larger 
or  heavier  machines  and  handling  the  bulkier  materials.  The 
probability  is  that  burden  charges  have  no  constant  relation  to 
wages.  When,  however,  they  have  such  a  constant  relation,  wages 
constitute  a  good  basis  for  the  distribution  of  burden.  If  burden 
is  $400,000,  and  wages  are  $1,000,000,  the  burden  is  40%;  and 
40%  of  the  amount  charged  to  each  job  for  wages  would  be  added 
for  burden. 

Distribution  of  Burden  on  Prime  Cost.  To  avoid  the  unfair- 
ness of  distribution  on  either  hours  of  labor  or  wages,  sometimes 
prime  cost,  or  the  sum  of  the  cost  of  raw  material  consumed  and 
wages,  is  used.  If  the  total  burden  for  the  year  is  $400,000,  the 
cost  of  raw  material  is  $300,000,  and  the  wages  are  $1,000,000,  a 
ratio  is  established  of  i^^'  or  30.7^  burden  chargeable  for 
every  dollar  of  wages  and  raw  material.  This  is  simple,  and 
easily  applied,  and  fair  when  conditions  are  right.  Clearly,  how- 
ever, when  high-wage  men  are  working  on  high-cost  material  by 
hand  for  one  job,  and  low- wage  men  are  working  on  low-cost 
material  with  high-cost  and  high-power  machinery  for  another, 
conditions  are  not  at  all  adapted  to  this  sort  of  blanket  rate  —  for 
here  the  burden  charged  to  the  first  job  is  high,  and  to  the  second 
job  is  low,  and  yet  all  the  cost  for  depreciation  of  machinery  and 
for  power,  and  much  of  that  for  housing,  should  be  charged  to  the 
second  job  and  little  of  these  to  the  first,  and  the  first  should  not 
have  any  charge  that  the  second  should  not  also  get  —  except 
possibly  supervision,  and  usually  it  is  the  low-rate  men  rather 
than  the  high-rate  men  who  need  that. 

Other  Blanket  Methods.  Observation  of  the  three  methods 
just  described  makes  clear  that  the  conditions  under  which  any 
blanket  method  is  good  are  limited  to  those  of  something  ap- 
proaching similarity  not  only  of  product  but  of  conditions  of  pro- 


396  THE  FUNDAMENTALS  OF  ACCOUNTING 

duction.  If  the  difference  between  products  is  chiefly  a  difference 
of  one  or  two  elements,  and  the  other  elements  of  cost  go  along 
parallel  with  them,  a  blanket  method  is  both  easy  to  apply  and 
satisfactory;  but  the  moment  some  costs  go  in  one  direction  and 
others  in  another,  something  else  than  a  blanket  method  must  be 
adopted. 

Brief  Analysis  of  Burden.  The  subject  of  distribution  of  bur- 
den is  big  enough  for  a  book  much  larger  than  this.  We  can  hope 
here,  therefore,  only  to  note  the  principles  of  distribution,  and  can 
observe  only  very  briefly  the  methods  of  distribution  on  an  ana- 
lyzed, as  contrasted  with  a  blanket,  basis.  For  this  we  must  note 
that  burden  naturally  has  relations  with  at  least  five  aspects  of 
production,  and  that  a  minimum  analysis  will  proceed  to  make 
distribution  with  regard  to  those  aspects  —  though  possibly  in 
practice  a  common  method  may  apply  to  two  or  more  of  them. 
These  five  are  Raw  Material,  Labor,  Buildings,  Machinery,  and 
Administration.  Virtually  every  element  of  production  can  be 
attached  as  a  part  of,  or  tributary  to,  one  of  these.  It  will  be 
found,  moreover,  that  burden  costs  do  not  necessarily  run  parallel 
in  all  five  of  these  aspects:  that  is,  the  burden  costs  connected 
with  raw  material,  like  insurance,  may  go  up  with  a  greater  value 
of  raw  material  going  into  the  product,  while  this  very  change  in 
the  character  of  the  raw  material  may  make  possible  the  use  of 
less  supervision  of  labor,  less  heat  and  Hght,  less  power  and  wear 
and  tear  for  machinery,  and  less  expense  of  administration.  In- 
stallation of  automatic  machinery  may  increase  heavily  main- 
tenance and  depreciation  of  machinery,  but  at  the  same  time 
reduce  supervision  of  labor,  space  required  for  housing  the  work, 
and  administrative  expense.  These  illustrations  make  clear  that 
anything  approaching  a  scientific  method  for  distribution  of  bur- 
den will  recognize  several  different  bases  —  though  of  course 
where  two  different  bases  give  the  same  method  of  distribution 
they  may  be  combined.  The  most  common  method  of  attaching 
burden  as  a  result  of  analysis  (contrasted  with  blanket  methods) 
utihzes  a  "machine  rate,"  so-called,  for  a  considerable  part  of  the 
distribution.  Without  attempting  a  complete  discussion  of  ma- 
chine rates,  or  even  of  any  one  out  of  the  variety  in  use,  we  may 
well  note  the  underlying  principle. 


FINDING  COST  OF  PRODUCTS  OR  SERVICES  397 

The  Principle  of  Machine  Rates.  In  factories  making  use  of  a 
variety  of  machinery,  of  which  not  all  is  used  uniformly  for  all 
product,  a  large  part  of  the  burden  is  found  to  be  related  to  the 
various  machines,  and  can  be  distributed  on  the  basis  of  the  num- 
ber of  hours  that  the  various  machines  were  employed  on  the  vari- 
ous products.  This,  however,  does  not  throw  all  machines  to- 
gether to  give  machine  hours,  as  could  be  done  to  form  a  blanket 
rate  substituted  for  the  labor-hour  rate,  but  estabhshes  a  different 
rate  for  each  machine  or  type  of  machine  on  the  strength  of  an 
analysis  of  each  machine's  requirements  of  burden.  The  method 
of  procedure  is  roughly  as  follows:  all  costs  connected  with  the 
land  and  buildings  are  gathered,  to  find  the  total  cost  for  space; 
this  space  cost  is  then  apportioned  to  various  departments,  like 
storehouse,  power  house,  shop,  and  office,  on  square  feet  or  cubic 
feet  of  space  occupied;  the  shop  share  of  space  cost  is  then  appor- 
tioned among  the  machines,  or  types  of  machines,  in  the  shop;  the 
total  power  costs  are  gathered,  and  this  is  apportioned  among 
machines  on  the  basis  of  horse-power  consumption;  then  costs 
pecuHar  to  each  machine  or  t)^e  of  machine  are  calculated,  such 
as  insurance,  taxes,  maintenance,  and  depreciation;  the  sum  of  all 
such  costs  for  each  machine  or  group  of  machines  is  then  divided 
by  the  number  of  working  hours  for  the  period  used  for  figuring 
costs  (usually  a  year),  and  the  quotient  is  the  hour-rate  for  this 
machine  —  the  rate  to  be  charged  per  hour  to  all  product  making 
use  of  this  machine.  The  details  of  calculating  and  distributing 
space  cost,  power  cost,  etc.,  are  handled  differently  under  differ- 
ent machine-rate  methods;  but  in  general  principle  virtually  all 
aim  at  the  same  thing  —  though  the  difference  in  results  is  some- 
times wide  because  of  wise  or  unwise  handling  of  the  figures  ob- 
tained.   Both  good  and  bad  machine  rates  are  in  use. 

Supplements  to  Machine  Rates.  The  machine  rates,  even 
where  they  are  most  complete,  do  not  take  care  of  all  burden  — 
for  they  cannot  except  by  mere  arbitrariness,  which  it  is  their 
purpose  to  avoid,  take  care  of  the  burden  connected  with  stores, 
with  general  supervision  of  labor,  or  with  administration,  and 
they  have  taken  care  of  space  costs  only  so  far  as  space  costs  are 
connected  with  the  machines.  These  remaining  items  of  burden 
may  be  attached  in  various  ways,  though  the  most  common  is  as 


398  THE  FUNDAMENTALS  OF  ACCOUNTING 

percentages  of  the  costs  with  which  they  are  directly  connected. 
Some  of  these  are  illustrated,  without  comment,  in  the  fourth  cost 
sheet  shown  below.  Roughly,  this  completes  our  burden  charges 
to  be  distributed  for  production  —  though  we  have  not  discussed 
minor  items  that  will  fall  into  the  general  plan,  or  burden  for  sell- 
ing cost,  which  follows  the  same  general  principles. 

Cost  Sheets  Illustrated.  In  order  that  we  may  see  these  four 
general  methods  together,  sunomary  cost  sheets  are  appended,  by 
way  of  review  or  summary,  for  the  same  product  under  the  four 
plans  described.  The  difference  in  cost  shown  throws  no  credit 
or  discredit  on  any  method:  the  fact  is  that  each. method  is  good  in 
its  place,  and  no  two  of  these  methods  would  often  produce  quite 
the  same  result.  It  happens  in  this  case  that  the  machine-rate 
method  was  adapted  to  the  circimistances  and  the  others  were  not. 


Cost  Sheet 

Burden  on  Hour  Basis 

Raw  Material  $7 .  00 

Labor,  1 2  hrs.  @  80^  9 .  60 

Burden,  12  hrs.  @  40^  4.80 

$21.40 


Cost  Sheet 

Burden  on  Wages  Basis 

Raw  Material  $7 .  00 

Labor,  1 2  hrs.  @  8oj!f  9 .  60 

Burden,  40%  of  wages  3.84 

$20.44 


Cost  Sheet 
Burden  on  Prime-Cost  Basis 


Raw  Material 
Labor,  12  hrs.  @  8oj!f 

Burden,  30.7%  of  Prime 


$7.00 
9.60 

$16.60 
510 

$21.70 


Cost  Sheet 

Analyzed  Basis 

Raw  Material  $7.00 

Additional,  10%  .70 

Labor,  12  hrs.  @  8of5  9.60 

Additional,  12  hrs.  ©3^  .36 

Machine  Rate,  3hrs.@25ff      .75 


Administration,  5% 


$18.41 

'9^ 

$19-33 


It  will  be  observed  that  the  total  burden  in  the  last  case  is  $2.73  — 
much  less  than  in  the  other  three  cases.  This  is  because  this  job 
happened  to  involve  somewhat  less  machinery  than  most  Jobs, 
whereas  under  all  three  of  the  other  methods  the  use  of  machinery 
is  not  recognized  as  a  separate  element  and  each  job  is  charged  for 
an  average  use  of  machinery  whatever  actual  use  it  makes  of  ma- 
chinery. This  job,  moreover,  had  more  raw  material  in  propor- 
tion to  labor  than  the  average  job,  and  hence  is  charged  more  for 


FINDING  COST  OF  PRODUCTS  OR  SERVICES         399 

burden  on  the  prime-cost  basis  than  under  any  other,  for  this 
basis  puts  the  same  weight  on  raw  material  as  on  labor.  Lastly, 
the  rate  of  wages  here  is  below  the  average,  and  hence  less  is 
charged  on  the  wages  basis  than  on  the  labor  basis. 

Interest  as  Cost  of  Production.  Much  has  been  written  of  late 
about  the  relation  of  interest  on  investment  —  as  investment  in 
machinery,  in  stores  carried  in  the  storeroom,  etc.  —  to  costs.  This 
is  no  place  to  argue  the  matter,  and  the  argument  heretofore  pub- 
lished indicates  that  to  great  extent  people  who  differ  are  talking 
about  different  things  and  obviously  enough  cannot  be  brought  to 
a  common  ground  by  any  discussion  here.  One  thing  does  con- 
cern us  here,  however,  and  any  theory  which  neglects  it  is  in  prac- 
tice dangerous,  however  interesting  or  however  futile  it  may  be  as 
economic  speculation:  to  attempt  to  compare  the  cost  of  two  prod- 
ucts, one  of  which  is  made  largely  by  machinery  and  the  other  of 
which  is  made  chiefly  by  hand,  and  omit  from  the  comparison  all 
recognition  of  invested  capital  is  to  run  the  risk  that  the  figures, 
of  which  the  purpose  is  to  make  comparisons,  will  be  incompara- 
ble and  hence  misleading.  If  two  products  cost  each  $5.00  for 
raw  material  and  $8.00  for  labor  and  $2.00  for  burden  ^  exclusive 
of  interest  on  the  value  of  investment  used,  but  one  is  made  wholly 
by  hand  and  the  other  involves  the  use  of  a  machine  costing  $500, 
it  is  nonsense  to  say  that,  for  any  purpose  for  which  accounts  are 
kept,  the  two  products  are  reported  comparably  when  we  say  that 
each  cost  $15.00  only.  The  purpose  of  cost  finding  is  quite  as 
much  comparative  as  absolute.  If  the  products  cost  the  same, 
they  may  be  sold  for  the  same  figure  and  yet  yield  the  same  profit. 
Then  a  sale  of  one  for  $18.00  means  the  same  thing  as  a  sale  of 
the  otiier  for  $18.00.  If  that  is  true  a  man  whose  product  costs 
$15.00,  though  he  uses  machinery  and  does  not  count  it,  should 
sell  his  goods  at  the  same  price  as  one  whose  product  costs  $15.00 
without  using  machinery.  If  reply  is  made  that  the  cost  is  the 
same  for  the  two  articles,  but  one  must  yield  more  profit  than  the 
other  because  the  owner  of  the  machine  must  meet  not  only  costs 
but  additional  profit  to  cover  the  use  of  his  investment,  the  dis- 
pute is  merely  over  the  use  of  terms,  cost  vs,  profit;  but  in  that 

*  The  burden  in  the  machine-made  product  includes,  of  course,  maintenance  and 
d^redation  of  machines,  so  that  capital  has  not  been  depleted. 


40O  THE  FUNDAMENTALS  OF  ACCOUNTING 

case  it  is  admitted  that  the  $15.00  figures  for  the  two  products  are 
not  comparable,  for  one  product  needs  to  have  added  to  it  profit 
of  one  magnitude  and  the  other  profit  of  another.  Yet  one  of  the 
purposes  of  our  cost  accounting  is  to  get  comparable  figures  — 
figures  that  enable  us  to  see  what  prices  must  be  obtained  for 
various  products  to  make  them  worth  our  making,  or,  if  prices 
are  independent  of  our  operations,  what  articles  we  can  and  can- 
not afford  to  make.  Yet  if  after  we  have  got  our  comparative 
figures  we  must  go  over  them  again  and  calculate  different  rates 
of  profit  to  be  added  to  different  articles  to  bring  them  up  to  neces- 
sary standards  of  selHng  price,  we  have  vastly  increased  our  labor 
for  the  mere  sake  of  maintaining  a  point  of  pure  theory  about 
the  relation  between  cost  and  profit  (virtually  every  well-known 
economist  considers  interest  a  cost).  The  convenient  thing,  the 
natural  thing  by  cost-accounting  methods,  the  thing  which  ac- 
cords with  economic  terms  and  usage,  is  to  treat  interest  on  in- 
vestment as  (i)  one  of  the  debits  to  operation,  so  that  we  may 
make  comparisons  between  different  articles  of  production  by 
putting  them  on  the  same  basis,  and  (2)  one  of  the  credits  to  in- 
come on  investment  in  the  business.  The  effect  of  this  is  to 
charge  product,  through  burden  (particularly  through  machine 
rates,  and  virtually  all  machine-rate  calculations  in  use  include 
interest  on  the  investment  in  the  machine),  and  to  credit  Interest 
Earned:  a  cost  of  production  (and  hence  a  reduction  of  profits 
below  what  they  would  be  if  interest  were  neglected),  offset  by 
income  on  investment  —  a  charge  to  one  department  of  the  busi- 
ness, so  to  speak,  by  another  department,  and  producing  com- 
parable figures  of  production  in  the  department  charged. 

Interest  as  Cost  on  the  Balance  Sheet.  One  objection  made  to 
treating  interest  as  cost  of  production  is  that  for  goods  (finished 
or  unfinished)  left  on  hand  at  the  end  of  a  period  the  balance 
sheet  shows  not  only  external  cost,  cost  out  of  pocket,  but  also,  to 
the  extent  of  the  interest  element  in  the  goods  still  on  hand,  cost 
to  one  department  of  the  business  (the  factory)  which  includes  a 
profit  (interest)  for  another  department;  and  hence  the  profits  are 
to  that  extent  only  on  paper  and  the  assets  are  also  to  that  extent 
only  on  paper.  This  objection  would  have  much  more  weight  if 
there  were  any  general  principle  that  could  be  applied  to  all  the 


FINDING  COST  OF  PRODUCTS  OR  SERVICES         40I 

items  on  a  balance  sheet  alike;  but  we  have  already  seen  that  some 
are  preferably  carried  at  cost,  and  some  at  market,  and  some  at 
collectibility,  and  some  at  gross,  and  some  at  net.  Each  item,  in 
a  sense,  has  its  formula  for  interpretation.  Then  why  not  goods 
in  process  and  finished  goods? 

Another  Phase  of  Interest  as  Cost.  Any  who  wish  further  to 
consider  interest  as  cost  are  urged  to  consider  the  case  of  the  pur- 
chase of  a  leasehold  as  given  on  page  372.  By  investing  in  the 
purchase  of  a  lease,  the  purchaser  was  able  to  hire  for  $10,000  a 
year  a  building  worth  $13,000  a  year.  The  amortisation  of  the 
lease,  however,  amounted  to  $1,841.74  in  the  first  year.  Does 
this  mean  that  the  rent  in  the  first  year  was  $11,841.74  ($10,000 
for  the  landlord,  and  $1,841.74  for  amortisation)?  For  the  first 
year  the  purchaser  of  the  lease  had  $23,165.21  locked  up  in  the 
hands  of  the  buyer,  and  none  of  it  could  be  ever  got  back  except 
as  he  realized  a  saving  of  $3,000  on  his  rental  charge.  The  origi- 
nal calculation,  which  fixed  the  value  of  the  lease,  calculated  one 
yearns  interest  on  this  investment  as  $1,158.26,  and  counted  it  as  a 
part  of  what  the  purchaser  must  give  up  in  return  for  the  $3,000 
that  he  was  to  get  in  a  saving  of  rent  —  as  a  part  of  the  cost. 
What  sort  of  accounting  information  should  we  get  in  this  case  il 
we  entered  rent  as  $11,841.74  and  let  it  appear  that  $23,165.21  of 
the  purchaser's  money  was  lying  idle?  How  should  we  find  costs 
of  doing  business,  percentages  of  net  profits  from  sales,  and  other 
figures  of  importance  for  comparative  purposes,  if  rent  were  taken 
here  at  $11,841.74,  and  we  had  a  similar  store  next  door  which, 
since  the  old  lease  had  recently  expired,  was  now  paying  $13,000 
in  cash  as  rental?  Comparisons  cannot  be  made  without  com- 
parable figures,  and  if  some  figures  are  on  a  current  basis  and 
others  are  partly  on  a  capital  basis,  adjustment  must  be  made  to 
convert  the  capital  figures  into  current;  but  whether  one  calls  the 
item  of  adjustment  cost  or  profit  is  largely  a  matter  of  taste. 

Finding  Costs  Illustrated.  By  way  of  summary,  ledger  ac- 
counts are  shown  below  for  a  simple  series  of  cost  transactions. 
No  attempt  is  made  to  show  more  than  a  few  typical  accounts, 
but  enough  are  shown  to  indicate  the  general  course  of  procedure. 
For  simpHcity,  small  amounts  are  used  for  financial  figures,  and 
they  may  be  taken  as  hundreds  or  thousands  of  dollars  if  one  can 


402  THE  FUNDAMENTALS  OF  ACCOUNTING 

appreciate  them  better  in  that  way.  The  debits  to  the  following 
accounts  represent  dealings  with  the  outside  world:  Raw  Mate- 
rial, Fuel,  Rent,  Insurance,  Taxes,  Administration  (cash  part 
only).  These,  with  the  corresponding  credits  to  Cash  and  to  Ac- 
counts Payable,  were  put  on  the  books  in  the  ordinary  course  of 
business  independently  of  any  special  thought  of  cost  accounting. 
The  other  entries  for  costs  follow:  a  debit  to  Manufacturing  (the 
controlling  account  for  costs  of  product,  identical  with  Goods-in- 
Process)  and  a  credit  to  Raw  Material  for  stores  issued;  a  credit 
to  Wages  for  pay  roll,  with  a  debit  to  Manufacturing  for  direct 
labor  on  jobs,  to  Power  for  power-house  wages,  to  Superintend- 
ence for  supervision  of  labor;  a  debit  to  Wages  and  a  credit  to 
Cash  for  actual  payments  made  on  wages.  A  debit  to  Power  and 
a  credit  to  Fuel  for  fuel  used  in  the  power  house;  and  distribution 
of  power  costs  by  a  credit  to  Power  and  a  debit  to  Heat  and  to 
Burden  (the  latter  for  power  used  in  the  manufacturing  processes) ; 
a  debit  to  Space  Cost  and  a  credit  to  Heat;  a  debit  to  Space  Cost 
and  a  credit  to  Rent;  a  credit  to  Space  Cost  and  a  debit  to  Burden 
for  the  share  of  space  cost  chargeable  to  direct  manufacturing 
processes,  and  to  Administration  for  the  share  chargeable  to  gen- 
eral purposes;  a  debit  to  Burden  Interest  and  a  credit  to  Interest 
Earned  for  interest  on  the  investment  in  manufacturing  facilities, 
a  debit  to  Burden  and  a  credit  to  Insurance,  to  Burden  Interest, 
to  Taxes,  to  Superintendence,  and  to  Administration,  to  close  all 
but  the  first;  a  debit  to  Manufacturing  and  a  credit  to  Burden  to 
close  the  latter;  a  debit  to  Finished  Goods  and  a  credit  to  Manu- 
facturing for  the  goods  transferred  from  the  factory  to  the  ware- 
house, at  cost  as  shown  by  the  cost  sheets;  a  debit  to  Sold  Goods 
and  a  credit  to  Finished  Goods  for  the  cost  of  goods  sold  (i.e.,  for 
the  same  amount  as  the  debit  to  Finished  Goods  when  the  par- 
ticular goods  sold  were  sent  into  the  warehouse).  It  will  be 
observed  that  several  clearing  accounts  have  been  used:  Power, 
Space  Cost,  Administration,  Burden,  and  Manufacturing. 

Raw  Material 


Accounts  Payable 

246 

Manufacturing 
Balance 

218 
28 

Balance 

28 

246 

FINDING  COST  OF  PRODUCTS  OR  SERVICES 


403 


Cash 
Balance 


Cash 


Balance 


Wages 
299       Manufacturing 
38       Power 

Superintendence 


Balance 


Fuel 


19 

19 
3 


Power 
Balance 


315 

4 

JE? 

337 
38 


26 

J. 
19 


Wages 
Fuel 


Power 


4 
16 

20 


Heat 
Burden 


3 

U 

20 


Power 


Heat 

3  III  Space  Cost 


Cash 


Rent 
23  III  Space  Cost 


2$ 


Heat 
Rent 


Space  Cost 


3 

Burden 

z8 

23 
26 

Administration 

8 
26 

Cash 


Insurance 
4  III  Burden 


Interest  Earned 


Burden  Interest 
5  III  Burden 


Cash 


Taxes 
6  III  Burden 


Interest  Earned 

IIJ  Burden  Interest 


404  THE  FUNDAMENTALS  OF  ACCOUNTING 


Superintendence 

Wages 

i8  III  Burden 
Administkation 

18 

Cash 
Space  Cost 

II 

_8 

Burden 

19 

12 

£2 

Burden 

Power 

Space  Cost 

Insurance 

Burden  Interest 

Taxes 

Superintendence 

Administration 

17 
18 

4 

5 

6 

18 

19 

Manufacturing 

87 

|Z 

i 

Manufacturing 

Raw  Material 
Wages              o 
Burden 

218 
87 

Finished  Goods 
Balance 

580 
40 

Balance 

620 
40 

620 

Finished  Goods 

Manufacturing 

S8o 

Sold  Goods 
Balance 

Soo 
80 

Balance 

58^ 
80 

580 

Sold  Goods 

Finished  Goods 

SCO  III 
Cash 

III  Sundries 

362 

Accounts  Payable 

II 

1  Raw  Material 

246 

It  will  have  been  observed  that  though  here  all  costs  go  ultimately 
to  Manufacturing,  some  go  indirectly,  for  we  wish  to  get  certain 


FINDING  COST  OF  PRODUCTS  OR  SERVICES         405 

statistical  figures  by  the  way.  Some  wages,  for  example,  go  di- 
rectly to  Manufacturing,  some  to  Power,  and  some  to  Superin- 
tendence —  but  these  latter  are  closed  in  turn  to  Manufacturing. 
These  figures  give  the  following  trial  balance: 


Trial  Balance 

Raw  Material 

28 

Wages 

38 

Fuel 

3 

Interest  Earned 

5 

Manufacturing 

40 

Finished  Goods 

80 

Sold  Goods 

500 

Cash 

362 

Accounts  Payable 

246 

651 

651 

All  accounts  here  but  two  are  real.     Sold  Goods  is  to  be  trans- 
ferred to  Trading,  and  Interest  Earned  to  Income. 

Ancient  or  Current  History?  The  closing  of  the  books  as  de- 
scribed above  has  been  on  the  assumption  that  the  year's  business 
was  over  before  the  closing  entries  were  made.  This  may  do  for 
books,  but  it  will  not  do  for  cost  sheets  or  for  guidance  in  quick 
decisions  during  the  year.  One  cannot  wait  until  December  3 1  to 
know  the  cost  of  burden  on  jobs  to  be  bid  for  in  March,  and  if  cost 
sheets  could  not  be  filled  out  imtil  after  Dec.  31  for  any  year  most 
of  them  probably  would  never  be  fiUed  out  at  all.  The  method 
actually  used  is  to  apply  the  experience  of  the  past  to  the  calcula- 
tions of  the  present,  adjusted  to  the  changed  conditions  of  the  pres- 
ent, and  to  employ  those  adjusted  figures  for  current  work.  The 
figures  for  raw  material  and  for  labor  may  be  known  currently: 
only  the  burden  charges  need  estimate;  but  if  careful  record  has 
been  kept  of  past  burden  (especially  if  it  is  an  analyzed  and  not  a 
blanket  burden),  adjustment  to  current  changes  may  be  readily 
made.  Then,  in  order  to  show  what  burden  has  actually  been 
absorbed  by  jobs,  entry  is  made  on  the  books  debiting  Manufactur- 
ing and  crediting  Burden  (or  whatever  accounts  are  kept  for  bur- 
den) whenever  burden  is  calculated  and  entered  on  cost  sheets. 
This  debits  Manufacturing  currently  for  actual  raw  material,  for 
actual  wages,  and  for  estimated  burden;  and  it  credits  Burden 


4o6       -(the  fundamentals  of  accounting 

currently  for  the  estimated  burden  charged  to  jobs.  Burden  will 
not  be  debited,  however,  until  actual  costs  of  burden  are  known 
at  the  end  of  the  period,  as  the  other  accounts  are  closed  to  it. 
When  it  is  so  debited  for  actual  costs  the  balance  of  the  account, 
which  is  the  difference  between  the  costs  as  found  and  the  esti- 
mates (corrected  by  constant  observation)  actually  used,  is  the 
measure  of  inaccuracy  —  a  help  to  greater  accuracy  in  the  subse- 
quent period.  This  discrepancy  is  then  transferred  to  Manufac- 
turing to  bring  that  account  into  agreement  with  the  final  facts. 
Where  the  work  is  well  done,  the  final  adjustment  at  the  end  of 
the  period  is  trifling  in  amount. 

The  Purposes  of  Cost  Accounting.  Now  that  we  have  seen 
what  cost  accounting  can  do,  let  us  notice  what  we  should  have  in 
mind  as  the  purposes  that  it  ought  to  serve.  These  are  three:  (i) 
to  guide  in  price-making,  when  we  can  make  prices;  (2)  to  guide 
in  eliminating  waste  and  other  unnecessary  expense;  (3)  to  guide 
in  deciding  what  we  had  better  do  and  what  we  had  better  avoid. 
The  first  of  these  is  accomplished  by  showing  the  total  cost  of 
specific  products  or  services.  The  second  is  accomplished  by 
showing  details  of  cost  —  elements,  processes,  groups  of  elements, 
groups  of  processes.  The  third  is  accomplished  by  showing  either 
that  the  total  cost  is  so  great  that  no  satisfactory  margin  of  profit 
remains,  or  that  some  specific  elements  cost  so  much  as  to  be  not 
worth  while,  even  though  other  costs  are  not  excessive.  In  this 
last  case,  we  may  find  that  still  it  pays  to  manufacture  the  product, 
for  we  may  have  some  elements  or  processes  contributed  from  out- 
side of  our  own  establishment.  If  we  did  not  have  detailed  costs 
we  could  not  know  that  this  is  desirable.  We  may,  on  the  other 
hand,  decide  that  it  is  worth  our  while  to  equip  ourselves  to  do 
the  work  inside,  even  at  apparent  greater  cost,  for  dependence  on 
others  is  often  too  hazardous.  Our  cost  accounts  can  at  least  indi- 
cate to  us  how  much  independence  costs,  and  this  we  should 
know. 

Wide  Applicability  of  These  Prmciples.  What  has  been  said 
of  finding  costs  for  particular  products  applies  equally  to  various 
kinds  of  services,  like  those  rendered  by  railroads,  electric  light 
companies,  hospitals,  schools,  and  hotels,  and  to  selling  organiza- 
tions like  department  stores.    An  important  element  in  the  ad^ 


FINDING  COST  OF  PRODUCTS  OR  SERVICES         407 

ministration  of  department  stores,  for  example,  is  the  lay-out  of 
the  store,  the  geographical  relation  between  departments,  and  the 
distribution  of  space  costs  so  that  each  department  shall  have  a 
fair  opportunity  to  show  a  profit  and  yet  not  have  any  unfair 
advantage  over  other  departments.  In  all  businesses,  one  type 
of  cost  important  to  watch  is  the  fixed  and  semi-fixed  charges — 
costs  that  are  not  increased,  or  proportionally  increased,  with 
an  increase  in  production,  or  decreased  proportionally  with  a 
decrease  in  production.  A  recognition  of  these  costs,  with  watch- 
fulness to  make  fiillest  utilization  of  each  of  them,  is  fundamen- 
tal in  good  business  management,  for  it  does  more  than  almost 
anything  else  to  reduce  costs  per  unit  of  product.  The  burden 
which  they  comprise  must  be  borne  somehow,  and  policy  must 
often  be  guided  by  the  necessity  of  procuring  business  enough 
to  absorb  them.  Any  type  of  accoimting  that  neglects  these 
principles  is  ahnost  sure  to  fail  in  some  of  the  services  that  it 
might  render. 

QUESTIONS  AND  PROBLEMS 

I.  An  institution  combining  educational,  rehabilitative,  and  industrial 
efforts,  maintains  a  laundry,  a  market-gardening  plot,  a  wood-working 
shop,  and  a  printing  shop.  It  pays  low  wages,  though  different  for 
different  work,  on  a  day-wage  plan,  because  the  iimiates  are  given  in- 
struction and  special  care.  A  rough  accounting  method  is  desired  for 
finding  the  costs  of  products  of  the  four  departments  indicated  above. 
Three  general  methods  have  been  suggested  as  follows: 

(a)  attaching  all  cost  except  raw  material  (and  even  that  in  the  mar- 
ket-gardening) to  product  on  the  basis  of  the  number  of  hours  of 
labor  —  i.e.,  dividing  all  the  costs  (except  material)  of  these  four 
productive  enterprises  by  the  number  of  hours  of  labor  spent  in 
these  enterprises,  and  thus  find  a  cost  of  work  per  hour,  which, 
multipUed  by  the  number  of  hours  of  work  in  the  particular 
product,  gives  (with  the  raw  material  cost)  the  total  cost  of 
the  product. 

(b)  using  machine-hours  as  well  as  labor-hours,  and  dividing  all  costs, 
as  before,  by  the  total  of  the  number  of  labor-hours  and  the  niun- 
ber  of  machine-hours,  obtaining  thus  a  rate  for  either  labor-hours 
or  machine-hours,  and  making  to  each  product  a  charge  equal  to 
this  rate  multipUed  by  the  combined  labor-hours  and  machine- 
hours  spent  on  the  product. 

(c)  distributing  costs  among  departments,  in  accordance  with  the 
benefit  which  the  several  departments  are  supposed  to  receive 


408  THE  FUNDAMENTALS  OF  ACCOUNTING ' 

/rom  the  expenditure,  and  then  using  within  each  department  for 
distributing  departmental  costs  to  the  several  products  of  that 
department  the  method  described  under  (b)  as  applying  to  all 
departments  together. 
Comment  upon  the  serviceability  of  each  of  these  methods  for  this 
institution. 

2.  Department  A  of  a  business  is  devoted  entirely  to  producing  fine  cabi- 
net work  on  special  orders  by  combined  hand  and  machine  production, 
the  former  predominating.  Department  B  makes  standard  articles,  of 
inexpensive  wood,  on  machines  constructed  for  this  production  and 
requiring  little  labor  and  less  supervision.  Department  C  takes  care 
of  a  variety  of  orders,  chiefly  the  manufacture  of  cheap  novelties,  and 
utilizes  both  hand  and  machine  work,  but  the  proportion  of  hand  and 
machine  work  is  constantly  varying  with  the  jobs  in  hand. 

What  comment  have  you  to  make  on  each  of  the  following  methods 
of  distributing  burden  costs? 

(a)  Finding  the  amount  of  direct  labor  cost  in  each  article  of  prod- 
uct, and  attaching  burden  as  a  percentage  of  that  labor  cost. 

(b)  Distributing  burden  between  departments  on  the  basis  of  com- 
parative costs  for  raw  material  consumed  in  each  department, 
and  then  distributing  that  burden  within  departments  over  the 
product  in  proportion  to  the  number  of  labor-hours  in  each 
article. 

(c)  Separating  all  burden  costs  into  four  groups  —  those  that  are 
connected  with  labor,  those  that  are  connected  with  machines, 
those  that  are  connected  with  both,  and  those  that  are  con- 
nected with  neither;  dividing  the  total  of  those  of  the  first  group 
by  the  number  of  labor-hours,  and  attaching  the  quotient  as  an 
additional  charge  to  each  article  of  product  for  each  hour  of  la- 
bor; dividing  the  total  costs  of  the  second  group  by  the  number  of 
machine-hours  run  and  charging  to  each  article  the  result  of 
multiplying  that  quotient  by  the  number  of  hours  the  article  was 
on  a  machine;  dividing  the  total  of  the  third  group  by  the  total 
machine-hours  and  man-hours  combined,  charging  each  article 
the  quotient  multiplied  by  the  total  hours  of  work,  man  and  ma- 
chine, spent  on  the  article;  dividing  the  total  of  the  fourth  group 
by  the  total  of  all  the  other  costs  and  applying  the  resulting  per- 
centage to  the  total  of  all  other  costs  for  each  article  produced. 

3.  It  is  common  to  say  that  the  cost  per  unit  is  affected  by  the  volume  of 
output.    Show: 

(a)  how  far  this  fact  affects  the  niunber  and  kind  of  accounts  to  be 
kept,  and  what  should  be  carried  to  them, 

(b)  how  far  the  accounts  can  tell  the  effect  of  changes  in  output. 

4.  A  gas  company,  anticipating  a  rise  in  the  price  of  coal,  bought  largely 
when  prices  were  low.  Prices  rose  so  rapidly  that  at  the  beginning  of 
the  next  operating  year  the  inventory  at  market  prices  was  higher  than 
at  cost  by  $100,000.  The  directors  wished  to  take  that  increase  in  value 


FINDING  COST  OF  PRODUCTS  OR  SERVICES         409 

into  the  balance  sheet,  and  to  use  the  increased  price  for  the  cost  of  con- 
sumption of  coal  in  the  subsequent  year;  but  the  treasurer  refused  to 
use  anything  but  costs.  At  the  end  of  the  year  profits  were  high,  for 
new  rates  had  been  based  on  the  market  price  of  coal. 

The  stock  of  coal  was  still  large,  but  the  treasurer  refused  to  carry 
it  or  to  issue  it  above  cost.  The  supply  lasted  six  months,  and  these 
showed  large  profit.  Near  the  end  of  the  period,  however,  the  com- 
munity discovered  that  the  coal  was  bought  at  the  old  price,  and  rates 
were  forced  down  to  their  old  figure.  In  the  subsequent  period  the 
company  was  buying  at  the  new  price,  charging  at  the  old  rates,  and 
accumulating  a  deficit  (the  previous  profits  had  been  distributed). 

From  the  pure  accounting  standpoint,  omitting  the  questions  of  non- 
accounting  business  policy,  should  the  records  have  been  kept  for  the 
year  and  a  half  of  exhaustion  of  old  stock  so  as  to  show  cost  of  pro- 
duction of  gas  at  the  old  cost  of  coal  or  at  the  new? 

Would  it  be  consistent  with  good  accounting  to  show  inventories  at 
cost,  but  to  issue  the  supply  for  manufacturing  purposes  at  the  market 
price?    Explain. 

What  are  the  functions  of  cost  accounting?  Show  how  they  are  served 
by  the  use  of  machine  rates. 

A  factory  has  several  machines  identical  in  cost  of  operation  and  in 
product,  but  bought  at  different  times,  and  ranging  in  cost  from  $2,000 
to  $4,000.  Is  the  cost  of  the  product  made  on  the  $2,000  machines  less 
than  that  made  on  the  $4,000  machines?    Why  or  why  not? 


APPENDIX  A 
DRAFTS 

Those  who  are  not  familiar  with  the  handling  of  drafts  will  have  diffi- 
culty in  understanding  the  accounting  for  them.  A  brief  discussion  of 
drafts  is  therefore  inserted  here. 

A  draft  serves  as  a  means  of  transmitting  funds,  and  as  a  means  of 
facilitating  collection.  In  the  first  case,  it  is  a  convenience  to  have 
funds  paid  where  they  are  desired  ultimately  to  go,  and  hence  a  draft  is 
drawn  on  somebody  in  that  place,  or  nearer  to  it  than  is  the  drawer  of 
the  draft,  and  given  to  one  who  desires  funds  in  that  place.  In  the 
second  case,  the  fact  that  a  draft  is  presented  for  payment  is  a  strong 
reminder  that  the  drawer  expects  the  money  to  be  paid,  and  some- 
times a  draft  may  be  sold  in  advance  of  its  due  date  and  thus  enable 
the  drawer  to  realize  funds  earlier  than  otherwise. 

A  draft  is  an  order  of  one  person  or  firm  or  corporation  requesting  a 
second  person  or  firm  or  corporation  to  pay  certain  specified  sums,  at  a 
time  designated,  to  a  person,  firm,  or  corporation  designated.  The 
following  is  an  illustration: 

^     ,    jao^  Washington,  D.C,  April  29,  1925 

100 

Thirty  days  after  sight,  pay  to  the  order  of  James  Munroe 
and  Company 

fifteen  hundred  sixty  — , Dollars 

100 

and  charge  the  same  to  our  account. 

To  John  Adams  William  Williams  &  Son 

Quincy,  Illinois 

Several  different  circumstances  may  be  attached  to  both  the  relation 
between  the  parties  concerned  in  a  draft,  and  the  time  of  payment. 

With  respect  to  the  parties  concerned,  we  will  first  note  a  name  for 
each.  The  " drawer"  of  the  draft  is  the  active  agent,  the  signer  of  it, 
who  makes  the  request  for  payment.  The  "drawee"  is  the  passive 
party,  on  whom  the  draft  is  drawn,  who  must  ultimately  pay.  The 
*' payee"  is  to  receive  the  money.  The  drawer  may  also  be  the  payee 
—  in  which  case  it  is  obvious  that  the  purpose  of  the  draft  is  not  to 
transmit  funds,  for  they  would  go  to  the  same  destination  without  any 
draft,  but  to  facilitate  collection  —  though  sometimes  when  a  draft 
is  drawn  payable  to  the  drawer  it  is  later  endorsed  to  some  one  else  and 


412  APPENDIX  A 

serves  the  same  purpose  as  if  drawn  to  the  other  payee  in  the  first  in- 
stance. The  drawee  may  or  may  not  owe  the  money  to  the  drawer. 
He  is  under  no  legal  obligation  to  pay  the  draft  in  any  case,  unless  he 
has  signed  a  contract  to  do  so,  because  for  reasons  of  his  own  he  may 
prefer  to  pay  his  creditor  direct  rather  than  some  one  else  at  his  credi- 
tor's order;  and  if  he  does  not  owe  the  money  he  has  no  reason  to  pay 
the  draft  —  except  as  an  accommodation  or  loan  to  the  drawer.  The 
drawer  may  owe  money  to  the  payee,  and  draw  the  draft  as  a  means  of 
payment,  or  he  may  draw  it  as  a  means  of  making  a  loan  to  the  payee. 
If  the  drawer  wishes  to  borrow  money  on  the  strength  of  funds  payable 
to  him  in  the  future,  he  may  draw  a  draft  payable  at  the  time  payment 
to  him  is  due,  and  sell  that  draft  to  a  bank  —  which,  of  course,  will  take 
out  interest  and  pay  him  less  than  the  face  of  the  draft. 

With  respect  to  maturity,  a  draft  may  be  drawn  payable  "at  sight," 
so  many  days  "after  sight,"  so  many  days  "after  date."  If  drawn  at 
sight,  the  drawee  pays  it  if  he  chooses,  or  refuses  to  pay  it.  If  he  refuses 
to  pay  it,  the  draft  is  worthless  paper  (but  as  he  may  change  his  mind 
later,  it  should  not  be  left  about  carelessly).  If  he  pays  it,  he  keeps  it 
as  a  receipt  for  the  money  paid.  If  a  draft  is  payable  "after  sight,"  it 
must  be  presented  for  acceptance  in  advance  of  presentation  for  pay- 
ment, else  it  will  never  become  due.  Acceptance  consists  in  writing 
the  word  "Accepted"  and  signing  the  name  of  the  drawee  across  the 
face  of  the  draft.  If,  on  the  other  hand,  it  is  payable  "after  date,"  it 
becomes  nominally  due  on  the  date  indicated  whether  it  has  been  pre- 
viously accepted  or  not;  but  as  the  drawee  has  the  option  of  accepting 
or  refusing  the  draft,  he  may  refuse  to  pay  it  when  nominally  due  even 
though  he  would  have  accepted  it  (and  would  now  pay)  if  it  had  been 
presented  to  him  for  acceptance  promptly  —  giving  him  courteous 
notice  of  its  existence.  If  payable  "after  sight,"  the  acceptance  must, 
of  course,  be  dated;  if  payable  "after  date,"  no  date  is  needed  in  the 
acceptance,  because  the  period  before  maturity  runs  from  the  date  of 
the  draft  itself. 

A  debtor  cannot  by  drawing  a  draft  in  favor  of  his  creditor  get  rid  of 
his  responsibility  for  the  debt  unless  the  draft  is  paid;  for  the  draft  may 
not  be  accepted,  and  it  may  not  be  paid  even  though  accepted.  The 
drawer,  in  other  words,  is  still  contingently  liable  on  his  original  debt 
imtil  actual  payment  of  the  draft.  A  transfer  by  the  payee,  moreover, 
holds  him  also  responsible,  by  endorsement,  to  the  transferee. 

The  entries  for  drafts  are  obvious  when  the  handling  of  drafts  is 
clear.  The  mere  drawing  of  a  draft  does  not  in  itself  necessitate  any 
entry,  for  the  draft  may  never  be  paid  or  even  accepted.  Usually  only 
a  memorandum  is  made,  for  record,  in  the  bill  book  discussed  in  Chap- 
ter XV.    Often,  however,  sight  drafts  are  entered  in  full  at  once  as  if 


APPENDIX  A  413 

paid,  for  since  they  are  due  at  once  one  will  hear  promptly  in  case  they 
are  not  paid,  and  it  is  in  some  businesses  less  work  to  make  correction 
entries  for  those  not  paid  than  to  watch  and  remember  to  enter  later 
those  from  which  one  may  hear  nothing  (because  paid  and  no  letter  of 
acknowledgment  was  sent).  With  time  drafts,  entry  is  customarily 
made  only  when  acceptance  is  known.  In  any  case,  whenever  entry  is 
made  for  drawing  a  draft,  the  drawee  is  credited,  for  he  has  either  paid 
his  debt  to  that  degree  or  has  made  a  loan;  and  the  payee  is  debited  for 
the  reverse  reason  —  except  when  the  draft  is  drawn  in  the  drawer's 
own  favor,  in  which  case  the  debit  is  to  the  accoimt  representing  the 
asset  got,  which  is  Notes  Receivable  if  the  accepted  draft  is  kept,  is 
Cash  (less  discoimt)  if  the  draft  is  sold  for  cash,  or  is  the  transferree  in 
case  the  draft  is  transferred  by  endorsement  to  some  one  else.  The 
drawee,  on  the  other  hand,  if  he  pays  the  draft  at  sight  will  debit  the 
drawer  and  credit  cash;  if  he  accepts  the  draft  for  future  payment,  he 
will  debit  the  drawer  and  credit  Notes  Payable.  The  payee  will  in  any 
case  credit  the  drawer,  as  the  source  of  the  asset,  and  will  debit  cash,  in 
case  the  draft  is  paid  at  sight,  or  Notes  Receivable,  in  case  it  is  accepted 
for  future  payment.  It  will  be  noted  that  the  drawee  does  not  care  to 
whom  he  pays  the  amount  of  the  draft,  but  only  for  whom  he  pays 
it;  and  the  payee  does  not  caxe  from  whom  he  collects,  but  only  on 
whose  order  he  collects. 

QUESTIONS  AND  PROBLEMS 

X.  John  Richardson  draws  a  sight  draft  for  $1,000  on  Richard  Johnson, 
who  owes  him  $1,000  for  merchandise  purchased,  in  favor  of  S.  Peter- 
son to  whom  Richardson  owes  $1,000  for  the  purchase  of  materials. 
The  draft  is  accepted  and  paid.  What  entry  or  entries  will  be  made 
on  the  books  of  Richardson,  of  Johnson,  and  of  Peterson? 

2.  M.  Lay  ton  draws  a  draft  for  $537.50  payable  30  days  after  date  on  John 
Ames  who  owes  him  that  amount  due  on  that  day  on  accounts  receivable. 
Ames  accepts  the  draft.  Ten  days  later  Layton  endorses  the  draft 
over  to  James  Smith  in  part  payment  of  a  debt  which  falls  due  in  twenty 
days.  Ames  pays  the  draft  at  maturity.  What  entries  will  be  made 
on  the  books  of  each  of  the  parties  concerned? 

3.  A  B  &  Co.  draw  a  draft  on  H I  &  Co.  in  favor  of  S  T  &  Co.  for  $r,ooo, 
payable  in  ten  days.  S  T  &  Co.  owe  H  I  &  Co.  $1,000  payable  in  ten 
days,  and  at  H I  &  Co.*s  acceptance  of  the  draft  leave  it  with  them,  ask- 
ing to  have  it  applied  against  their  own  debt.  What  entries  should  be 
made  on  the  books  of  each  of  the  parties  concerned? 


APPENDIX  B 

SIMPLE  INTEREST  AND  BANK  DISCOUNT 

For  ordinary  purposes  of  business  not  connected  with  investment, 
simple  interest  and  bank  discount  are  commonly  used.  Virtually 
every  business  transaction  involving  the  future  involves  in  one  way  or 
another  interest  or  discount.  Even  when  no  mention  is  made  of  inter- 
est or  discount  they  are  likely  to  be  taken  into  consideration  in  the 
bargain.  Theoretically  in  that  case  the  books  should  show  the  facts; 
but  usually  the  amount  is  too  small,  or  too  imcertain,  or  too  much  in- 
volved with  other  things,  to  make  worth  while  the  recognition  of  inter- 
est unless  it  is  named  as  a  part  of  the  bargain  —  though  in  long-term 
transactions  involving  investments  it  is  always  worth  recognition  in 
the  accounts.  When  goods  are  sold  with  terms  of  payment  in  the 
future,  interest  is  an  element  in  the  price,  even  though  not  named;  for 
one  can  always  buy  cheapest  for  cash;  but  it  is  not  usual  to  attempt  to 
distinguish  that  part  which  is  interest  and  that  which  is  the  equivalent 
of  the  cash  price  of  the  goods. 

Where  interest  is  involved  in  a  transaction  with  a  negotiable  instru- 
ment, however,  a  note  or  a  draft,  it  is  always  taken  into  consideration 
and  entry  —  unless,  indeed,  as  in  rare  cases,  of  which  we  shall  observe 
some  later,  interest  is  shown  by  the  consideration  to  be  not  really  in- 
volved. Notes  may  or  may  not  bear  interest.  They  do  not  unless 
interest  is  specified  in  the  text  of  the  note.  If  they  do  not  bear  interest, 
they  are  not  worth  face  value  until  the  day  when  they  become  due  — 
for  the  owner  must  until  then  wait  for  his  money,  and  he  expects  com- 
pensation for  waiting.  If,  therefore,  I  wish  to  borrow  money,  and 
wish  to  give  my  promissory  note  payable  in  60  days  without  interest  as 
evidence  of  my  debt,  I  must  make  the  note  for  a  larger  amoimt  than 
the  amount  that  I  wish  to  borrow;  for  no  one  will  (except  as  a  matter 
of  charity)  lend  money  to-day  and  wait  without  compensation  two 
months  for  repayment.  The  note  must  be  enough  larger  than  the  loan 
to  cover  interest  on  the  loan  for  two  months.  If,  on  the  other  hand, 
the  note  bears  interest,  it  will  be  worth  its  face  value,  for  the  delay  in 
payment  is,  by  the  terms  of  the  note  itself,  to  be  compensated  by  a 
payment  at  maturity  larger  than  the  face  of  the  note.  A  sample  form 
of  note  follows.  If  it  did  not  bear  interest,  the  words  "with  interest" 
would  be  omitted.  A  place  of  payment  may  or  may  not  be  specified. 
When  not  so  specified,  the  usual  place  of  business  of  the  maker  of 
the  note  is  understood. 


APPENDIX  B  415 

•y  5qo  J^  Washington,  D,C.,  Jan.  i,  1924 

''       100 

Sixty  days  from  date  I  promise  to  pay  to  the  order  of  the  United 

States  National  Bank  seven  thousand  six  hundred  —    ....  Dollars, 

100  * 

for  value  received,  with  interest. 

X.  Y.  Zee 

The  words  "for  value  received"  are  deemed  to  make  the  note  legally 
collectible,  for  they  make  it  a  part  of  a  contract;  whereas  without  these 
or  similar  words  the  note  would  be  a  mere  promise,  and  promises  with- 
out consideration  are  not  binding  at  law;  so  in  default  of  these  words 
burden  of  proof  of  legal  claim  is  placed  on  the  holder  of  the  note  in  case 
payment  is  refused,  whereas  when  these  words  are  attached  the  burden 
of  defense  is  on  the  maker  of  the  note  if  he  refuses  to  pay. 

When  the  compensation  for  the  use  of  money  is  made  in  addition  to 
the  face  of  the  note,  so  that  the  payee  of  the  note  collects  more  than  its 
face,  it  is  called  *' interest,"  whether  actually  it  is  paid  in  advance, 
during  the  life  of  the  note,  or  at  its  maturity.  When  the  compensation 
is  not  in  addition  to  the  face,  that  is,  when  the  payee  collects  only  the 
face  of  the  note  but  gets  his  interest  from  the  fact  that  he  originally 
lent  (or  otherwise  gave  value)  less  than  the  face  of  the  note,  it  is  called 
"  discount."  The  face  of  a  note  plus  any  interest  to  be  paid  at  matur- 
ity is  called  the  "amount";  and  the  face  of  a  note  minus  the  discount 
is  called  the  "present  worth."  These  terms,  moreover,  are  not  con- 
fined to  notes,  but  are  used  of  all  values  subject  to  interest  and  dis- 
count. 

The  calculation  of  interest  may  be  made  in  many  ways.  The 
simplest  to  understand  and  the  easiest  to  apply  is  the  "  six-per-cent." 
method.  Whatever  the  actual  rate  of  interest,  six  per  cent,  is  used  and 
then  adjustment  is  made  for  any  diJfference  between  six  per  cent,  and 
the  actual  rate.  The  reason  for  this  is  that  six  per  cent,  gives  a  number 
of  figures  easily  subdivided,  so  that  most  of  the  calculation  can  be  done 
"in  the  head."  Six  per  cent,  a  year  is  the  same  as  one  per  cent,  for 
two  months,  and  for  purposes  of  figuring  interest  two  months  is  taken 
practically  for  most  business  transactions  as  sixty  days.  So  six  per 
cent,  a  year  is  one  per  cent,  for  sixty  days;  but  sixty  is  divisible  by  two, 
three,  four,  five,  six,  ten,  twelve,  fifteen,  twenty,  and  thirty,  and  there-? 
fore  almost  at  a  glance  one  can  find  the  interest  for  any  number  of 
days.  The  days  not  seen  at  a  glance,  however,  are  combinations  of 
days  that  are  seen  at  a  glance.    Let  us  try  a  few  illustrations. 

What  is  the  interest  on  $247.18  for  three  months  and  eighteen  days 
at  six  per  cent.?    To  find  the  interest  for  two  months  we  have  but  to 


4l6  "  APPENDIX  B 

point  off  two  decimal  places  (one  per  cent.).  For  an  additional  month 
we  take  half  of  what  we  already  have  and  add  it.  For  six  days  we  have 
merely  to  point  off  three  decimal  places  (for  six  is  one-tenth  of  sixty, 
and  for  sixty  we  point  off  two);  and  so  for  eighteen  we  may  either 
write  down  $.247  and  add  to  it  double  itself,  or  multiply  our  original 
figure,  247.18,  by  three,  but  write  the  product  down  one  place  farther 
to  the  right  than  our  figures  derived  from  60  days.  The  whole  calcula- 
tion, then,  with  all  the  work,  is  as  follows: 

Method  I  Method  II 

$2.4718  (2  mo.)  $2.4718  (2  mo.) 

1 .  2359  (i  mo.)  1 .  2359  (i  mo.) 

.  2472  (6  ds.)  .7415  (18  ds.) 

•  4944  (12  ds.)  $4.45 

$4-45 

What  is  the  interest  on  $615.23  for  seven  months  and  seventeen  days 
at  4%?  Without  other  explanation  than  can  be  given  parenthetically 
in  the  solution,  the  working  out  follows. 

$  6.1523  (two  months) 
12.3046  (four  months  —  twice  two  months  —  building  up  toward  seven) 
3 .0761  (one  month  —  half  of  two  months  —  to  complete  seven) 
1 .  5381  (fifteen  days  —  one-half  of  one  month) 
.2051  (two  days  —  one-third  of  six  days) 
$23.28      (at  6%) 

7.76      (less  one-third) 
$15.52      (at  4%) 

Though  theoretically  there  is  no  reason  why  it  should  be  so,  in  prac- 
tice the  rate  of  discount  is  usually  higher  than  the  rate  of  interest.  If  I 
borrow  $500  and  give  my  note  for  $500,  with  interest,  for  two  months, 
at  the  end  of  the  time  I  pay  $505  —  supposing  interest  to  be  at  6%. 
If  I  make  a  note  for  $500,  payable  in  two  months  without  interest,  and 
discount  it,  I  get  $495  and  at  the  end  of  the  time  pay  $500.  In  the 
first  case  I  pay  $5  interest  for  the  use  of  $500,  and  in  the  second  case  I 
pay  $5  interest  for  the  use  of  $495.  In  the  second  case  I  pay  interest 
on  the  face  of  the  note,  though  I  borrowed  only  the  present  worth  of  it. 
This  discount  is  not  true  discount,  which  will  be  discussed  in  Appendix 
C,  but "  bank  discount,"  so-called.  It  is  the  discount  commonly  taken 
by  banks,  and  for  short  terms  between  man  and  man.  When  banks, 
moreover,  make  loans  on  notes  bearing  interest,  they  usually  add  the 
interest  to  the  face  of  the  note,  take  the  discoimt  on  the  sum  of  face  and 
interest,  and  give  the  borrower  the  balance.  They  thus  get  their  in- 
terest in  advance. 


APPENDIX  B  417 

Let  us  now  observe  a  few  notes  and  find  their  value. 


Date 

ofnoU 

Amount 

Term 

Due 

Semiring 
Interest 

Value 
Jan.  X 

Value 
Peb.i 

Value 
Mar.x 

Jan.  I 

1000 

2  mos. 

Mar.  I 

None 

990 

995 

1000 

Jan.  I 
Jan.  I 

1000 
1000 

2  mos. 
2  mos. 

Mar.  I 
Mar.  I 

6% 
6% 

1000 
(at  a  bank) 
999.90 

1005 
(at  a  bank) 
1004.9s 

lOIO 
lOIO 

If  the  first  note  mentioned  above  is  discounted  on  January  i  or  on 
February  i,  the  interest  is  paid  in  advance.  The  purchaser  or  dis- 
counter, on  the  other  hand,  is  collecting  money  in  advance  of  rendering 
the  service.  The  second  note  is  always,  except  at  a  bank  (and  suppos- 
ing it  is  good),  worth  its  face,  and  the  longer  it  is  held  the  greater  is  the 
accrued  interest  upon  it;  the  third  is  the  same  note  as  the  second. 

If  a  note  is  given  in  payment  of  a  debt,  it  may  for  the  purpose  of 
paying  the  debt  have  a  value  different  from  its  market  value.  If  a 
man  buys  $1,000  worth  of  goods  on  January  i  with  a  four  months' 
term  of  credit,  and  then  on  March  i  gives  his  creditor  a  note  payable  in 
two  months  for  $1,000,  what  is  the  note  worth?  It  is  worth  $990;  and 
it  could  be  discounted  for  that  only  (at  6%) ;  but  for  the  purpose  of 
paying  the  bill  it  is  worth  $1,000  and  must  be  credited  to  the  customer 
at  that  figure;  for  it  calls  for  $1,000  when  the  $1,000  is  due  and  hence  is 
good  payment.  The  simple  fact  is  that  neither  the  note  nor  the  mer- 
chandise is  worth  $1,000  (else  why  was  four  months  given  for  pay- 
ment?), and  one  is  as  good  as  the  other. 

QUESTIONS  AND  PROBLEMS 

1.  (a)  Find  the  interest  on  $789.66  for  77  days  @  7%. 

(b)  Find  the  interest  on  $2,240.98  from  February  i  to  June  30  @  5%. 

2.  A  holds  two  notes  which  he  discounts  on  February  i  at  his  bank.  The 
first  is  for  $550,  is  payable  on  February  28,  and  does  not  bear  interest. 
The  second  is  for  $1,270,  is  dated  January  i,  is  due  on  March  15,  and 
bears  interest  @  5%.  How  much  will  the  bank  give  him  for  each  note 
if  its  rate  of  discount  is  6%? 

3.  A  has  a  note  for  $2,000,  dated  January  i  and  due  July  i,  bearing  inter- 
est @  5%.  On  March  i  A  gives  the  note  to  B  in  exact  full  payment  of 
a  bill.  On  July  i  B  collects  the  note.  What  entries  for  the  note  will 
be  made  on  the  books  of  A  and  of  B  on  March  i  and  on  July  i? 


APPENDIX  C 

COMPOUND  INTEREST,  COMPOUND  DISCOUNT, 
AND  ANNUITIES 

When  a  loan  or  other  financial  relation  has  a  long  existence,  its  value 
cannot  be  determined  by  a  multiplication  of  the  annual  rate  of  interest 
by  the  term  of  the  loan  or  other  relation;  for  it  is  the  custom  of  business 
to  pay  interest  at  least  as  often  as  annually,  and  a  loan  running  fif- 
teen years  (and  loans  on  bonds  commonly  run  longer)  would  normally 
have  interest  paid  at  least  fifteen  times  during  its  life  rather  than  at 
the  end  of  the  loan  only.  In  order  to  compare  the  value  of  two  invest- 
ments, we  must  put  them  on  a  comparable  basis.  Money  actively 
invested  in  business  by  a  proprietor,  or  partner,  or  stockholder,  is 
supposed  to  be  earning  income  constantly,  and  that  income  may  be 
realized  (and  is  almost  universally  calculated  and  available  for  with- 
drawal) at  least  as  often  as  annually.  If  we  are  to  compare  loans  and 
other  investments,  we  must  put  them  all  on  a  periodical-settlement 
basis.  So  all  long-term  financial  relations,  however  payment  is  ac- 
tually made,  are  valued  on  a  basis  of  periodic  settlement  of  interest. 
If  the  actual  settlement  of  interest  is  seldom,  they  are  less  valuable, 
for  the  recipient  of  the  interest  will  have  to  wait  longer  for  his  money 
and  will  therefore  discount  more  heavily:  if  the  settlement  of  interest 
is  frequent,  they  are  more  valuable  —  for  the  interest  payments  may 
be  themselves  invested  and  earn  more  interest.  Unless  stipulation  is 
made  to  the  contrary,  interest  is  supposed  to  be  payable  annually,  and 
calculations  are  based  on  that  assumption. 

No  interest  can  be  calculated  without  a  rate,  and  consequently 
when  a  future  value  is  to  be  determined  a  rate  must  be  fixed  upon. 
The  rate  of  interest  is  always  dependent  in  part  on  the  risk  involved. 
To  some  people  we  would  not  lend  for  the  promise  of  two  hundred  per 
cent,  interest,  but  to  others  we  might  lend  for  five;  for  in  some  cases  we 
should  think  the  chance  of  losing  even  our  principal  was  large.  The 
first  step  in  calculating  a  future  value  is  fixing  upon  the  rate  to  be  used, 
called  the  "basis  rate."  That  is  not  a  matter  of  mathematics,  or  of 
accounting,  but  of  business  judgment  with  which  accounting  has 
nothing  to  do  but  to  use  the  rate  found. 

We  commonly  have  two  classes  of  value  to  find:  future  values  of 
future  sums,  and  present  values  of  future  sums;  these  sums,  moreover, 
whether  present  or  future,  may  be  single  sums  or  a  series  of  sums  pay- 
able periodically,  commonly  called  "annuities."    We  wish  a  means  of 


APPENDIX  C  41^ 

finding,  then,  four  things:  the  future  values  of  sums  now  in  hand,  sup- 
posing the  value  now  in  hand  is  invested  and  earns  the  normal  rate  of 
interest  on  investment  of  its  class;  the  present  value  of  sums  to  come  to 
hand  in  the  future  but  without  interest  payments  in  the  meantime; 
the  future  value  of  sums  to  come  to  hand  periodically  in  the  future  and 
put  at  interest;  and  the  present  value  of  sums  to  come  to  hand  period- 
ically in  the  future  but  without  interest. 

The  first  step  is  to  realize  that,  since  the  normal  operation  of  business 
yields  return  on  investment  in  the  form  of  profit  or  interest  or  divi- 
dends at  least  as  often  as  annually  (when  return  is  made  at  all),  in 
finding  the  value  of  long- term  relations  we  usually  assume  that  interest 
will  normally  be  received  annually.  A  siun  of  money  in  hand  to-day, 
therefore,  if  kept  invested  at  6%,  will  grow  in  the  following  way: 
starting  at  $1,000,  in  one  year  it  will  earn  $60,  and  the  amount  will  be 
$1,060;  but  the  $60  being  invested  will  itself  earn  $3.60,  and  the  second 
yearns  interest  will  be  $63.60,  which  added  to  the  $1,060  at  the  end  of 
the  first  year  gives  $1,123.60  at  the  end  of  the  second  year;  this  whole 
sum  (original  sum  and  two  interest  sums)  will  be  earning  in  the  third 
year,  and  the  interest  will  be  $67.42,  so  that  the  amount  at  the  end  of 
that  year  will  be  $1 ,191.02.  This  process  can  be  continued  indefinitely. 
Each  interest  is  added  to  the  amornit  at  the  end  of  the  preceding  year, 
and  a  new  interest  is  calculated  and  added.  Those  who  have  ad- 
vanced somewhat  in  arithmetic  know  that  this  may  be  expressed  in  a 
formula.  If  P  is  the  principal,  or  original  siun,  and  p  is  the  number  of 
periods,  and  r  is  the  rate  of  interest,  the  amount  equals  P  (i-l-r)* . 
In  this  case,  our  formula  is  1,000  (1.06)^. 

This  is  the  formula  for  the  future  value  of  a  single  present  sum  in 
hand  to  accumulate  from  interest.  Calculations  involving  many  pe- 
riods are  very  tedious;  but  they  may  be  simply  and  easily  made  by  the 
use  of  logarithms  and  the  formula  just  given;  but  logarithms  lie  beyond 
the  field  of  this  book. 

Let  us  turn  next  to  the  present  value  of  single  sums  to  come  to  hand 
in  the  future.  What  is  the  value  of  a  legacy  of  $3 ,000  due  to  be  paid  in 
three  years?  We  are  concerned  here  not  with  bank  discount,  which 
takes  out  interest  on  more  money  than  is  lent,  but  with  true  discoimt. 
What  is  the  value  to-day  of  $1,000  due  in  one  year,  if  6%  is  the  basis 
rate?  The  real  value  is  the  sum  which  put  at  interest  for  one  year  at 
6%  will  amount  to  $1,000  in  one  year.  This  can  be  easily  found. 
One  dollar  put  at  interest  for  one  year  at  6%  will  at  the  end  of  the 
year  amount  to  $1.06.  If  each  dollar  will  in  a  year  amount  to  $1.06, 
the  number  of  dollars  which  will  in  a  year  amount  to  $1,000  is  repre- 
sented by  the  number  of  times  $1.06  is  contained  in  $1,000,  or  $943.40 , 
($1,000  -^  1.06  =  $943.40).    This  is  easily  proved:  6%  of  $943.40  is 


420  APPENDIX  C 

$56.60;  and  $943.40  4-  $56.60  =  $1,000.  The  true  discount  of  $1,000 
for  one  year  at  6%,  then,  is  $1,000  —  $943.40,  or  $56.60:  the  discount 
on  the  principal  sum,  $1,000,  is  the  same  as  the  interest  on  the  present 
worth.  That  is  why  bank  discount  is  at  a  higher  rate :  it  takes  interest 
on  the  principal  rather  than  on  the  present  worth  (which  is  all  that 
has  been  lent). 

What  is  the  value  to-day  of  $1 ,000  due  in  two  years?  It  is  not  $1 ,000 
minus  twice  the  true  discount  for  one  year,  or  $1,000— $113.20;  for  that 
would  neglect  the  fact  that  if  interest  were  paid  annually  one  could  in- 
vest the  interest  of  the  first  year  and  earn  something  with  it  in  the 
second,  and  that  the  interest  on  what  is  big  enough  to  amount  to 
$943.40  at  the  end  of  a  year  is  less  than  the  interest  on  what  will 
amount  to  $1,000  at  the  end  of  a  year.  The  value  of  $1,000  payable 
in  two  years  will  be  found  by  continuing  one  step  farther  the  process 
used  in  finding  the  value  for  one  year.  We  have  found  that  if  any  one 
had  $943.40  to-day,  and  invested  it  at  6%,  he  would  be  in  the  same 
condition  at  the  end  of  the  year  as  if  he  were  to  receive  $1,000  then. 
We  now  wish  to  know  how  much  he  must  have  one  year  earlier  than 
that,  or  two  years  before  the  $1,000  is  due,  to  have  $943.40  one  year 
before  the  $1,000  is  due.  This  is  found,  of  course,  by  dividing  $943.40 
by  1.06,  for  the  same  reason  that  we  divided  $1,000  by  1.06  in  the 
other  case.  This  gives  us  $890.00,  and  the  discount  for  the  second 
period  before  maturity  is  therefore  $53.40.  This  is  easily  proved: 
$890.00  in  one  year  will  earn  $53.40;  this  added  to  $890.00  gives 
$943.40;  this  in  the  second  year  will  earn  $56.60;  and  at  the  end  of 
two  years  we  have  $1,000.  Our  discount  for  the  two  years  is  $110, 
and  the  present  worth  for  two  years  is  $890  —  that  is,  the  value  to- 
day of  $1,000  payable  in  two  years.  For  three  years,  we  carry  the 
process  another  step  and  divide  $890.00  by  1.06,  and  get  $839.62. 
As  this  is  the  value  of  $1,000,  three  times  this  is  the  value  for 
$3,000,  which  we  started  to  find,  or  $2,518.86.  We  should  have  got 
the  same  result,  of  course,  by  dividing  $3,000  by  1.06,  and  the 
quotient  by  1.06,  and  that  quotient  in  turn  by  1.06.  If  one  prefers, 
however,  one  may  approach  from  the  other  end,  and  make  use  of 
what  we  found  regarding  accmnulations  of  interest.  We  have  just 
seen  that  the  present  worth  of  any  future  sum  is  the  principal  which 
will  amount  to  that  sum  in  the  given  niunber  of  periods;  and  we  found 
on  the  preceding  page  how  to  find  what  any  principal  will  amount  to  in 
any  number  of  periods.  So  now  we  may  find  the  present  worth  of  any 
siun  by  dividing  it  by  the  amoimt  of  one  dollar  for  that  number  of 
periods.    Those  who  desire  a  formula  can  construct  one  from  that  given 

for  the  other  sort  of  case.   Actually  it  is  .    .    v^,  or,  in  this  case,  ^^i* 

This  applies  to  any  sort  of  future  value.    When  the  number  of 


APPENDIX  C  421 

periods  is  large,  the  calculation  is  very  tedious  except  by  the  use  of 
logarithms. 

We  may  now  turn  to  periodic  payments.  These  are  much  more 
common  than  most  people  realize,  and  are  called  "annuities,"  whatever 
the  periodicity.  Any  periodic  fixed  payment  is  an  annuity  —  rent, 
salaries,  interest,  and  insurance  premiums,  for  example.  The  value  of 
any  annuity,  whether  present  or  future,  is  simply  the  sum  of  the  values 
of  the  separate  installments  of  which  it  is  made  up.  The  amount  of  an 
annuity  of  $1,000  a  year  for  three  years,  on  a  6%  basis  (which  assimies 
that  all  sums  received  are  to  be  invested  and  accumulated  by  adding 
the  interest),  is  the  simi  of  the  amounts  of  the  first  $1,000  for  three 
years  (if  the  installments  begin  inmiediately),  the  amoimt  of  another 
$1,000  for  two  years,  and  the  amount  of  a  third  thousand  for  one 
year;  or,  as  we  found  above,  on  page  419,  $1,191.02,  for  the  first 
installment,  $1,123.60  for  the  second,  and  $1,060  for  the  third,  or 
$3,374.62  for  the  annuity.  If,  on  the  other  hand,  the  installments  of 
annuity  were  paid  at  the  end  of  the  year,  the  first  would  earn  interest 
only  two  years  and  amount  to  only  $1,123.60,  the  second  for  one 
year  and  amount  to  $1,060,  and  the  third  would  have  no  opportunity  to 
earn  interest,  and  the  total  amoimt  would  be  only  $3 , 1 83 .  60.  Formulas 
for  the  values  of  annuities  can  be  constructed,  and  are  published;  but 
even  to  explain  one  of  them  here  would  carry  us  beyond  our  field. 

The  present  worth  of  an  annuity  is  merely  the  smn  of  the  present 
worths  of  the  various  installments  of  the  annuity.  An  annuity  of 
$1,000  a  year  for  three  years,  on  a  6%  basis,  therefore,  is  the  sum  of  the 
present  worth  of  $1,000  payable  in  one  year  (supposing  the  annuity  is 
first  payable  a  year  from  now),  of  the  present  worth  of  another  $1,000 
payable  in  two  years,  and  of  the  present  worth  of  a  third  $1,000  payable 
in  three  years;  or,  as  we  found  above,  on  page  420,  $943.40  for  the  first 
installment,  $890.00  for  the  second,  and  $839.62  for  the  third,  or  a  total 
of  $2,673.02  for  the  annuity.  If,  on  the  other  hand,  the  first  installment 
were  payable  at  once  the  values  would  be  $1,000  for  the  first,  $943.30 
for  the  second,  and  $890.00  for  the  third,  or  a  total  of  $2,833.40  for  the 
annuity.  Formulas  are  available  for  calculating  the  present  worth  of 
annuities,  but  they  would  carry  us  too  far  from  the  field  of  this  book. 

One  type  of  annuity  is  a  sinking  fund.  A  sinking  fimd  is  a  sum  of 
money  set  aside  periodically  and  invested,  along  with  the  interest  earned 
by  the  fund,  in  order  to  accumulate  by  a  certain  specified  time  a  certain 
sum  of  money  for  a  definite  purpose,  such  as  paying  debt,  or  replacing 
worn-out  machinery.  The  organizers  of  the  fund  need  to  know  how 
much  money  to  set  aside  periodically  in  order  to  build  up  the  proper 
amount  at  the  proper  time.  The  method  is  simply  to  divide  the  re- 
quired amoimt  by  the  amount  of  an  annuity  of  one  doUai:,  for  the  re- 


422  APPENDIX  C 

quired  number  of  periods,  and  at  the  rate  available.  If,  for  illustration, 
we  wish  to  know  how  much  we  must  set  aside  annually  to  accumulate 
$10,123.86  in  three  years  at  6%,  we  divide  that  amount  by  3.37462, 
the  amount  that  an  annuity  of  one  dollar  will  amount  to  in  three  years 
(the  amount  shown  on  page  421  for  $1,000  —  when  payments  begin 
at  once  —  divided  by  1,000)  and  get  $3,000. 

When  interest  is  assumed  to  be  or  is  actually  paid  oftener  than 
annually,  the  calculation  in  all  these  cases  uses  the  adjusted  rate  for 
the  adjusted  number  of  periods.  If  interest  is  semi-annual  rather  than 
annual,  we  for  every  case  above  use  3%  for  six  periods  (interest  or  dis- 
coimt)  instead  of  6%  for  three  periods  —  and  the  results  are  different 
because  of  the  more  frequent  compounding. 

For  the  convenience  of  the  reader  in  seeing  how  these  things  workout, 
and  in  trying  practice  problems,  tables  for  the  four  kinds  of  values  just 
discussed  are  given  on  pages  424  and  425  for  six  periods  and  for  eight 
rates  of  interest.  It  should  be  noted  that  the  values  are  for  the  most 
common  situation  for  each  kind  of  case,  and  that  the  tables  are  not 
uniform  in  respect  to  time.  The  table  of  present  worths  gives  the 
present  value  of  a  single  dollar  to  be  paid  at  the  end  of  the  period  named. 
The  table  of  amounts  gives  the  accumulated  amount  at  the  end  of  the 
period  named  for  a  dollar  in  hand  now.  The  tables  for  annuities,  both 
present  worth  and  amount,  are  for  an  annuity  on  which  no  payment 
is  made  until  the  end  of  the  first  period.  To  gain  familiarity  with 
the  significance  of  the  tables,  the  reader  is  reconmiended  to  observe: 
(i)  that  any  figure  in  the  table  for  present  worth  of  a  single  payment 
when  multiplied  by  the  figure  for  the  corresponding  rate  and  period 
in  the  table  for  amounts  will  give  $1.00  (for  this  puts  the  present  worth 
at  interest  to  earn  back  the  discount  taken  off) ;  (2)  that  the  present 
worth  of  an  annuity  for  one  period  is  the  same  as  the  present  worth 
of  a  single  payment  for  one  period  (for  they  are  the  same  thing); 
(3)  that  the  present  worth  of  an  annuity  is  the  siun  of  the  corresponding 
present  worths  of  the  installments  of  the  annuity;  (4)  that  the  parallel- 
ism does  not  hold  with  the  tables  for  amounts,  for  the  table  for  single 
payments  is  for  a  present  one  dollar,  whereas  the  table  for  annuities  is 
for  a  dollar  paid  at  the  end  of  each  period;  (5)  that  as  we  go  down  the 
periods,  the  difference  between  each  present  worth  and  the  next  gets 
smaller,  whereas  the  difference  between  each  amount  and  the  next 
gets  larger;  (6)  that  the  present  worth  of  any  single  payment  is  some- 
what more  than  the  present  worth  at  half  the  rate  for  twice  the  num- 
ber of  periods  (for  discounting  at  3%  for  4  periods  takes  off  more 
discount  than  discounting  at  6%  for  2  periods,  because  of  more  fre- 
quent compounding;  (7)  that  the  amount  of  any  single  payment  is 
somewhat  less  than  the  amoimt  at  half  the  rate  for  twice  the  number 


APPENDIX  C  423 

of  periods  (for  here  the  extra  compounding  at  the  lower  rate  adds  to 
the  interest,  whereas  in.the  case  of  present  worth  it  added  to  the  dis- 
count) ;  (8)  that  both  the  present  wortii  and  the  amount  for  any 
annuity  are  less  than  the  corresponding  figure  for  any  annuity  of 
half  the  sum  at  half  the  rate  for  twice  the  number  of  periods;  for 
with  respect  to  the  present  worth,  though  compounding  at  shorter 
intervals  with  the  lower  rate  tends  to  reduce  values,  the  more  fre- 
quent payment  of  installments  reduces  the  simis  remaining  to  be 
paid,  and  so  reduces  discounts  faster  than  the  more  frequent  com- 
poimding  builds  them  up;  and  with  respect  to  amounts,  both  the 
more  frequent  payments  and  the  more  frequent  compounding  add 
to  values. 

QUESTIONS  AND  PROBLEMS 

1.  How  from  the  tables  should  you  prove  or  disprove  each  of  the  following 
statements? 

(a)  A  sum  of  $10,000  is  due  in  five  years,  and  interest  at  6%  is  to  be 
paid  on  it;  but  by  agreement  the  interest  will  not  be  paid  until  ma- 
turity, when  interest  will  be  paid  on  the  interest  pajnnents  post- 
poned.   The  amount  to  be  paid  at  maturity  is  $13,382.26. 

(b)  The  present  worth  of  $5,000  payable  in  three  years,  on  an  interest 
basis  of  5%  in  semi-annual  installments,  is  $4,311.48.  Show  this 
from  two  tables. 

(c)  You  sell  your  right  for  two  years  to  an  annuity  pa)dng  $1,000 
a  half  year,  and  deem  5%  interest  payable  in  two  installments  to 
be  fair.  The  first  installment  of  the  annuity  will  be  due  in  six 
months.    You  should  get  $3,761.97.    Prove  this  from  two  tables. 

(d)  I  desire  to  accimiulate  $3,173.90  by  January  i,  1925.  Supposing 
,  I  can  earn  45%  interest,  paid  in  semi-annual  installments,  on  all 

sums  invested,  I  can  accumulate  the  desired  sum  in  due  season 
if  I  invest  $500  on  July  i,  J922,  and  a  like  sum  semi-annually 
thereafter,  and  invest  all  interest  received. 

2.  (a)  If  money  is  worth  5%  a  year  payable  in  semi-annual  installments, 

what  will  be  the  amount  of  $1 ,000,  put  at  interest  now  and  increased 
by  the  investment  of  the  interest,  in  two  years? 

(b)  What  is  the  present  worth  of  $10,000  payable  in  four  years  when 
money  is  worth  6%  annually? 

(c)  If  you  are  the  beneficiary  of  an  estate  which  yields  $10,000  at  the 
end  of  each  year,  and  you  each  year  on  receiving  the  income 
promptly  invest  it,  and  thereafter  invest  promptly  the  interest 
received,  and  earn  45%  annually,  how  much  will  you  have  at  the 
end  of  four  years  (with  the  $10,000  due  at  that  time)? 

(d)  If  instead  of  collecting  the  income  mentioned  in  (c)  you  sell  it  in 
advance,  what  should  you  get  for  it  to-day,  again  supposing  inter- 
est is  worth  4^%  annually? 


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426  APPENI)IX,C 

3.  Each  of  the  cases  indicated  below  represents  a  sum  or  sums  of  money 
to  be  received  in  the  future.  What  is  the  difference  in  present  value 
between  the  si^ns  when  the  interest  named  is  to  be  taken  as  annual 
and  when  it  is  to  be  taken  as  in  semi-annual  installments? 

(a)  $1,000  due  in  three  years,  when  money  is  worth  5%. 

(b)  $1,000  due  in  two  years,  when  money  is  worth  45%. 

(c)  Interest  on  a  5%  bond  for  $10,000,  to  run  two  years,  when 
money  is  worth  6%. 

(d)  The  amount  that  can  be  accumxilated  in  three  years  by  invest- 
ing at  4%  the  interest  that  is  receiyed  pn  a  $10,000  6%  bond 
with  three  years  to  run. 


APPENDIX  D 

SINGLE  ENTRY 

Tbroughout  this  book  double  entry  has  been  assumed  as  the  only  cor- 
rect system  of  bookkeeping.  The  reason  was  explained  in  Chapter  II. 
A  few  words  about  the  single-entry  system  may  be  interesting,  though 
they  can  serve  little  purpose  except  to  emphasize  the  advantage  of  the 
other. 

The  fundamental  distinction  is  that  theoretically  single  entry  has 
none  but  personal  accoimts.  When  a  transaction  involves  two  such 
accounts,  the  entry  is  necessarily  double,  a  credit  to  one  and  a  debit  to 
the  other.  If,  for  instance,  we  owe  Jones  and  pay  him  by  an  order  on 
Smith  who  owes  us,  we  must  debit  Jones  and  credit  Smith.  Theoreti- 
cally, by  single  entry  this  would  be  made  as  two  entries: 

J.  Jones  Dr.         2,500 

Paid  him  by  an  order  on  J.  Smith 

J.  Smith  Cr.  2,500 

By  an  order  to  pay  J.  Jones  for  our  account 

In  practice,  however,  these  are  often  combined  as  in  a  double-entry 
journal,  though  the  double  form  intervening  between  single  forms  is 
more  or  less  dangerous,  since  the  bookkeeper  may  not  notice  that  here 
two  postings  are  required. 

It  is  not  strictly  in  accordance  with  the  single-entry  theory  to  keep 
accounts  with  property,  such  as  merchandise  and  cash,  though  it  is  cus- 
tomary to  do  so. 

When  expenditures  are  for  such  things  as  interest,  expense,  etc.,  the 
normal  entry  would  be  to  disregard  the  nominal  account  entirely  and 
simply  credit  cash.  If,  however,  one  wished  to  keep  track  of  interest, 
an  account  could  be  kept  with  it,  posting  to  it  as  under  the  other  sys- 
tem.   Just  so  far,  however,  the  system  would  be  double  entry. 

Under  pure  single  entry,  therefore,  the  situation  is  as  follows:  the 
books  show  all  amounts  owing  and  all  amounts  owed;  the  resources  of 
other  sorts  may  be  counted  or  valued,  as  cash,  notes,  merchandise,  etc. 
The  difference  between  net  resources  and  net  liabilities  is  the  present 
worth  of  the  business  —  exactly  as  in  the  balance  sheet  by  double 
entry.  A  comparison  of  this  year's  present  worth  with  last  year's 
present  worth  (allowing  for  any  supposed  profits  withdrawn  by  pro- 
prietors or  as  dividends)  shows  profit  for  the  year  —  just  as  a  compari- 


428  APPENDIX  D 

son  of  two  balance  sheets  (with  allowance  for  supposed  profits  with- 
drawn) shows  profits  under  double  entry. 

So  far  as  single  entry  goes,  therefore,  it  attains  the  same  result  as 
double  entry.  We  must  note,  however,  what  is  missing.  In  Chapter 
XIV  we  saw  that  by  a  six-column  statement  we  derive  profits  in  two 
ways,  and  that  the  two  ways  actually  show  the  same  result.  On  such 
a  statement  we  compare  not  only  resources  and  liabilities,  but  also 
losses  and  gains.  We  know  not  only  how  much  we  have  made  and 
what  it  cost,  but  also  from  what  sources  we  made  it  and  how  the  cost 
was  incurred.  Single  entry  can  do  this,  to  be  sure,  by  keeping  extra 
accounts;  but  so  far  as  it  does  so  by  single-entry  methods  double  labor 
is  involved.  In  double  entry,  as  was  shown  in  Chapter  XI,  the  labor  is 
not  only  not  double,  but  practically  single.  Indeed,  full  double  entry 
by  double-entry  methods  is  far  less  laborious  than  partial  double  entry 
by  single-entry  methods.  Any  books  kept  so  that  any  entry  fails  to 
have  a  credit  for  its  debit,  or  vice  versa^  is  kept  by  single  entry:  as  the 
strength  of  a  chain  is  determined  by  the  strength  of  its  weakest  link, 
the  double-entry  or  single-entry  character  of  books  is  determined  by 
the  character  of  its  weakest  entry,  for  with  one  single-entry  record  the 
books  are  no  longer  in  balance  and  therefore  no  longer  have  the  double 
aspect.  Consequently  the  work  cannot  be  checked  by  the  double- 
entry  tests  —  agreement  of  the  two  sides  of  the  trial  balance,  agree- 
ment of  the  two  showings  of  loss  and  gain  on  a  six-column  statement, 
and  consistency  between  the  balance  sheet  and  the  income  sheet. 


INDEX 


Abstract,  subordinate  ledger,  i8o. 
Accounts  —  accrued  asset,  102-105. 
accrued  liability,  115. 
allowance,  107-111. 
asset,  specific,  88-106. 
balances  of,  meaning  of,  60,  158,  339. 
balancing  of,  144. 
clearing,  130-135- 

distributive,  131,  134. 

illustration  of,  132,  133,  135. 

nature  of,  130. 

purpose  of,  131. 

real  or  nominal,  135. 

summary,  131. 
closing  of,  144,  209-231. 
content  of,  84,  384-385. 
contingent,  93,  106,  116. 
contra,  107-112. 
controlling  —  applications  of,  182. 

check  on,  180. 

defined,  180. 

purpose  of,  181. 
corporation,  24^273. 
cost,  50-63,  384-386,  402-406. 
defined,  20. 
drawing,  112. 
form  of,  25, 143, 151-152. 
impersonal,  86. 
interpretation  of,  339,  343. 
inventory,  89,  216,  221. 
liability,  specific,  11 2-1 17. 
mixed,  79,  90. 
nominal  —  defined,  78. 

double  aspect  of,  117. 

nature  of,  78. 

profit  and  loss  from,  80. 

purpose  of,  84. 

related  to  real  account,  85, 117, 128. 

specific,  1 1 7-130. 
ownership-claim,  8,  21-23,  26,  2a-3i, 

112-117. 
partners,  11 2-1 13. 
jjersonal,  86. 
prepaid  asset,  103-105, 
prepaid  liability,  115. 
proprietors',  11 2-1 13. 
provision,  in. 
real  —  defined,  78. 

related  to  nominal  account,  85, 1x7, 
128. 
reserve,  107, 108,  266,  310, 332,  334. 
ruling  of,  145. 
suspense,  xo6. 


title  of,  56,  84,  87,  22Z. 

ultimate  cost,  390. 

uncollectible,  108,  124. 
Accounting  —  defined,  5. 

relation  to  bookkeeping,  4-6. 
Accounts  Payable  —  account  for,  114, 
178. 

as  controlling  account,  179. 

book  for,  239. 

defined,  9. 
Accounts  Receivable  —  account  for,  95, 
178. 

as  controlling  account,  179. 

book  for,  239. 

cash  sales  as,  95. 

defined,  8. 

doubtful,  account  for,  95. 

related  to  sales,  353. 

uncollectibility  of,  see  Bad  debts. 
Accumulation  on  bonds,  377-379. 
Adjustment  of  burden,  405. 
Administration,  398,  402. 
Advertising,  105,  127. 
Allowance  —  compared  with  reserve,  267. 

for  bad  debts,  108,  124-126,  340. 

for  depreciation,  107,  303,  305,  340. 

for  discount,  no,  114,  120-122,  340. 

for  future  payments,  230. 

purjxjse  of  account  for,  107,  303,  305. 
Amortisation  of  bonds,  377-379. 
Amoimt     (principal    plus    interest)  — 
formula  for  calculating,  419. 

illustrated,  419,  421,  422. 

table  for,  424,  425. 
Annuity  —  amount  of,  421, 

defined,  418. 

present  worth  of,  421, 

sinking  fund  as,  421. 

tables  of,  425. 
Appreciation,  81,  284,  290. 
Appropriations,  accounts  for,  246. 
Assets  —  accounts  for,  21-31,  87-106. 

accrued,  86,  102-105,  344. 

capital,  86,  288. 

classified,  86,  344. 

confused  with  profits,  263. 

contingent,  93,  106,  287,  344. 

conversion  of,  52-54,  60,  80. 

converted,  account  for,  72-76, 80, 134. 

current,  86,  344. 

deferred,  86,  344. 

determining  ownership<Iaims,  Z2. 

disposition  of,  10. 


430 


INDEX 


impermanence  of,  88. 
pledged,  355-358. 
prepaid,  86,  103-105,  344- 
sources  of,  10. 
tangible,  86. 
wasting,  310. 
working,  86,  344. 

Bad  debts,  allowance  for,  108,  124-126, 
340. 

loss  from,  q6,  124,  351. 
Balance    Sheet  —  adjustment    for,    39, 
53,  56,  58,  61,67,  72,  75,  209-231. 

analyzed,  341. 

classification  on  344. 

comparative,  346-350. 

form  of,  343-346. 

function  of,  313-315-  • 

illustrated,  8,  13-16,  152,  340,  345. 

indicating  credit,  314. 

indicating  going  values,  315-324. 

indicating  investment,  319. 

indicating  solvency,  314. 

informality  of,  345. 

interpretation  of,  339-343. 

interpreting  changes  on,  346-350. 

nature  of,  7-10. 

notes  supplementary  to,  346. 

order  of  items  on,  344. 

related  to  operating  statement,  47, 

351-355- 
Balancing,  see  Closing  books. 
Bankruptcy,  125,  249,  355-359- 
Basis  rate,  418. 
Betterments  defined,  301. 
Bill  book,  238. 

Bills  payable,  see  Notes  payable. 
Bills  receivable,  see  Notes  receivable. 
Bonds  —  accounting  for,  375,  380. 

accumulation  on,  377,  378. 

amortisation  of,  377-378. 

book  value  of,  377. 

defined,  273.  ■ 

discount  on,  374,  380. 

interest  on,  372. 

issued,  113,  380.  ^ 

optional-redemption,  381 

owned,  100. 

premium  on,  374,  380. 

sales  of,  379. 

value  of,  finding,  373,  376. 
Bookkeeping  —  defined,  4. 

relation  to  accounting,  4. 
Buildings,  99,  107. 
Burden  —  absorption  of,  405. 

adjustment  of,  405. 

analysis  of,,  396. 

current  estimate  of,  405. 

distribution  of,  393-399. 


blanket  bases  for,  395. 
illustrated,  398. 
labor-hour  basis  for,  394. 
machine-rate  basis  for,  397. 
need  of  proper,  392. 
prime-cost  basis  for,  395. 
wages  basis  for,  394. 
nature  of,  282,  390,  392. 
Business  as  entity,  18. 

Capital  —  charging  to,  311. 

gains  of,  290. 

increased  by  profits,  269. 

loss  of,  288. 

working,  260. 
Capital  deficit,  289. 
Capital  stock  —  accounts  for,  250,  252, 

25s- 

authorized,  252. 

common,  250. 

distinction  between  issue  and  sale  of, 
251. 

donations  of,  258-261. 

in  treasury,  loi,  255,  260. 

issued  at  above  par,  255, 

issued  at  below  par,  257. 

issued  at  par,  252-255. 

owned,  loi. 

preferred,  250. 

subscriptions  to,  253,  261. 

value  of,  250,  366. 

without  par  value,  272. 
Capital  surplus,  290,  372. 
Capitalization  —  bases  of,  312-324. 
actual-cost,  319^-324. 
cost-of -duplication,  315-317,  324. 
eaming.K:apacity,  317-319,  324. 

defined,  312. 

public  interest  in,  324. 
Cash  —  account  for,  89. 

petty,  89,  236. 
Cash  book,  168-170,  187-190,  237-238. 
Charity,  37. 

Checking,  172, 180,  195,  198,  241. 
Clearing  accounts,  set  Accounts,  clearing. 
Clients,  95. 

Closing    books  —  illustration    of,    144, 
151-152,  214-219,  402-405. 

methods  of,  213-223. 

purpose  of,  209. 

through  journal,  214-217,  219. 

through  ledger,  217-219  (bis). 
Columns,  labor-saving  by  special,  165-^ 

168,  179,  185-199. 
Commission,  41,  104,  115,  128,  351. 
Commitments,  246. 
Concessions,  369,  370. 
Contingent  assets,  93,  106,  287,  344. 
Contingent  liabilities,  93,  116,  344. 


INDEX 


43t 


Contra  items,  107-112, 186. 
Contracts,  106,  117,  287. 
Controlling  account,  see  Account,  con- 
trolling. 
Copyrights,  370. 
Corporations  —  accounting  for,  252-273. 

converted  from  private  business,  262. 

nature  of,  249. 
Cost,   account    for   each    element   of, 
50-52,  384-386,  407. 

accounts  for,  illustrated,  401-406. 

analysis  of,  384. 

as  basis  for  capitalization,  319-324. 

as  outlay,  280. 

average,  386,  389. 

burden,  see  Burden. 

confused  with  disposition  of  profits, 

329- 

defined,  276-281. 

departmental,  128,  135. 

difficulties  of  finding,  281,  283,  386. 

direct,  390,  391-392. 

division  of,  between  periods,  282. 

independent  of  replacement,  278. 

independent  of  selling  price,  277. 

indirect,  see  Burden. 

interest  as,  399-401. 

inventories  at,  284-287. 

joint,  see  Burden. 

nature  of,  276-281,  291. 

overhead,  see  Burden. 

prime,  391. 

space,  135,  402. 

special,  methods  of  finding,  389. 
Cost  accounting  —  applicability  of,  406. 

discussion  of,  50^67,  384-407. 

illustrations  of,  57-65,  398,  401-406. 

purposes  of,  50,  406. 
Cost  sheets,  389,  390,  398. 
Credit  —  illustrations  of,  27-31. 

meaning  of,  23-25. 

nature  of,  33,  41-43- 
Day  book,  146,  147. 
Debit  —  illustrations  of,  27-31. 

meaning  of,  23-25. 

nature  of,  33-41,  42. 
Debt  Joss  estimated,  125  (bis),  351. 
Deficiency  statement,  359. 
Deficit,  268,  289. 
Depletion,  310. 
Depreciation  —  account  for,  126. 

aJlowance  account  for,  107,  303,  305, 
340. 

appraisal  method  for,  306. 

as  conversion  of  asset,  35,  307,  351. 

bases  of,  302-306. 
reducing-balance,  303. 
formula  for,  303  n. 


reducing-fraction,  304. 
sinking-fund,  303. 
straight-line,  302. 
blanket  rates  for,  306. 
charted,  305. 
defined,  126. 
entries  for,  298-300. 
estimating,  301. 
nature  of,  35,  126,  295-298. 
objection  to  frequent  record  of,  300. 
of  merchandise,  325. 
of  new  property,  298. 
reserve  for,  107,  267,  332. 
temporary,  300. 
with  maintenance,  297. 
without  maintenance,  295. 
Discount  —  bank,  103,  416. 
bond,  374,  378,  381. 
cash  —  allowance  for  available,  no, 
114,  121,  340. 
allowance  for  offered,  no,  120,  122, 

340. 
as  profit  or  loss,  132. 
available,  121,  351. 
collected,  123. 
defined,  no,  128. 
entries  for,  no,  119-123,  128,  185- 

190. 
forfeited,  122. 
given,  119,  3*51. 
lost,  123. 
nature  of,  132. 
offered,  120,  351. 
on  operating  statement,  351 
taken,  121,  123,  351. 
stock,  257,  261. 
true,  416,  419. 
Disposition  of  income,  264-266,  330-337. 
Divided  entries,  172-174. 
Dividends  —  account  for,  264. 
effect  of  declaring,  263,  268-271,  351. 
stock,  271. 
Donations  of  stock,  258-261. 
Double  entry,  principle  of,  7,  12. 
Drafts,  91,  114,  411-413. 
Drawee,  411. 
Drawer,  411. 
Duplication,  cost  of,  278,  315-317. 

Eaming-capacity,  capitalization  of,  317- 

319,  324. 
Earnings,  see  also  Income;  Revenue. 
Eight-column  statement,  228. 
Electric  service,  193. 
Endorsement  —  accommodation,  116* 

on  note,  93,  94. 
Entity,  business  as,  18. 
Entry  —  as  evidence,  152. 

cancellation  of,  152. 


43^ 


INDEX 


correction,  153  (bis). 
defined,  149. 
division  of,  172-174. 
double,  principle  of,  7,  12. 
original  —  as  posting;  193. 
defined,  142,  148. 
form  of,  146. 

illustrations  of,  149-150,  166,  168, 
169,  171,  192,  198. 
Frosting  of,  142,  149,  151. 
single,  427. 
when  made,  66. 
Equipment,  99. 
Erasures,  152. 
Errors,  152,  159-163. 
Evidence,  books  of  original  entry  as, 

152,  174. 
Expansion,  effect  of,  354. 
Expenses  —  differentiated,   50-52,   385, 
407. 
general,  64,  128,  351. 
operating,  134. 
statistics  of,  182,  243. 

Factory  accounting,  182,  384-407. 
Finished  goods,  55,  90,  351,  402,  404. 
Fire,  loss  by,  see  Hazard. 
Fixed  charges,  407. 
Formulae  —  for  amounts,  419, 

for  depreciation,  303  (n). 

for  present  worths,  420. 
Franchise,  369. 

Freight  and  cartage,  119,  351. 
Fuel,  SI,  59,  64,  72,  135,  214,  216,  218, 

219,  351,  402. 
Funds  —  accounts  for,  loi. 

defined,  102. 

replacement,  309. 

sinking,  loi,  333,  421. 
Furniture  and  fixtures,  98. 

Guns,  290,  see  also  Loss  &  gain. 
Goods-in-process,  51-60,  70-73,  96,  134, 

35 1 »  402. 
Good  will,  262,  367-368. 

Hazard,  provision  for,  in,  266,  288, 332. 
Heat,  54,  402,  403. 

Impressed  system,  236. 

Income  —  as  clearing  account,  134. 

disposition  of,  264-266,  330-3;i7. 

(see  also  Loss  &  gain;  Revenue). 
Income  sheet  —  compared  with  operat- 
ing statement,  65. 

illustration  of,  46. 

purpose  of,  44. 

related  to  balance  sheet,  47. 

(see  also  Operating  statement). 


Indexing,  95, 142,  174,  199. 
Insolvency,  see  Bankruptcy. 
Insurance,  35,  36,  54,  64,  104,  in,  288, 

351,  402. 
Interest  —  accrued,  102,  115,  129,  209. 

as  cost,  54,  351,  399-401,  402. 

basis  rate  for,  418. 

charges,  104,  115,  118,  129,  209,  380. 

earned,  102,  117,  129,  209,  371,  376, 
400,  402. 

effect  of,  on  values,  365-381. 

general  discussion  of,  128,  209,  414- 

.  423. 

liability,  115,  129,  209. 

method  of  figuring,  415,  418-423. 

prepaid,  103,  129,  209. 

single  account  for,  209. 

six  per  cent,  method  for  finding,  415. 

unearned,  116,  129,  209. 
Inventories  —  accounts  for,  216,  221. 

basis  of,  284-287. 

taking,  70,  74,  97. 
Investment,  7-18, 112,  250-258,  272, 320. 
Investments,  100,  loi. 
Invoice  book,  170,  191. 

Joint  cost,  see  Burden. 
Journal  —  cash,  168. 

closing  through,  214-217,  219. 

columnar,  166. 

defined,  147-148. 

illustrated,  149-150. 

private,  201. 

purchase,  170,  191, 

sales,  171. 

subdivision  of,  167. 

use  of,  167,  172. 
Journalization,  147-150. 

Labor-saving  devices  —  abuse  of,  174, 

in  books  of  original  entry,  165-175, 
185-206. 

in  ledgers,  178-183. 
Leaseholds,  371. 
Ledger  —  as  book  of  original  entry,  193. 

balances  on,  use  of,  26,  158. 

balancing  of,  144. 

book  of  original  entry  as,  191. 

closing  of,  151-152,  214,  216,  218,  219, 
402-405. 

creditors,  179, 191. 

customers,  179, 183. 

expense,  182. 

factory,  182. 

form  of,  143, 151-152. 

general,  account  for,  201, 

illustration  of,  151,  402-404. 

private,  199-206. 

purchase,  179, 191. 


INDEX 


433 


purpose  of,  26, 142, 148. 

ruling  of,  145. 

sales,  179,  183. 

shipments,  183. 

statistics  on,  245-247. 

stockholders,  250. 

subordinate,  178,  180, 183. 

tabular,  193. 

totals  on,  use  of,  60,  64,  130,  158, 405. 
Liabilities,   86,   93,    11 2-1 16,   340-343» 
344,  355-358. 

(see  also  Ownership-claims). 
Liquidation,  313-31S1  340-343>  3SS-3S9- 
Loans,  partners',  113. 

(see   also   Notes   receivable;     Notes 
payable). 
Loose-leaf  books,  142, 154, 175. 
Loss  &  gain,  10,  12,  14,  15,  i5n,  46,  60, 

62,  74,  77,  81,  134,  264,  284,  379. 
Loss  from  bad  debts,  39,  124-126,  131, 
351. 

Machfaie  rates,  397,  398. 

Machinery,  99. 

Maintenance,    127,    295-301,    310-324, 

351- 
Manufacturmg,    as    cleanng   account, 

134,  404. 
Merchandise  —  as  clearing  account,  131. 

affected  by  discounts,  122-123,  132. 

as  inventory  account,  89. 

as  mixed  account,  90. 

depreciation  of,  325. 

inventoried,  284-286. 
Mortgage  notes,  94,  114. 
Municipal  administration,  246. 

Note  —  discount  of,  93,  415. 

endorsement  of,  93. 

illustrated,  415. 

interest-bearing,  414. 

value  of,  414-417. 

(see   also   Notes   receivable;     Notes 
payable). 
Note  book,  238. 
Notes  payable,  14,  15,  113. 

(see  also  Note). 
Notes  receivable  —  account  for,  91. 

discounted,  93. 

doubtful,  account  for,  94. 

protested,  94. 

(see  also  Note). 

Obsolescence,  see  Depreciation. 

Oil,  52. 

Operating  statement  —  illustrated,   64, 

3SI.    , 
nature  of,  50-63,  352. 
related  to  balance  sheet,  47,  3SX-355. 


related  to  income  sheet,  65. 

sources  of,  64,  80,  130-135. 
Optional-redemption  bonds,  381. 
Overhead,  see  Burden. 
Ownership-claims  —  accounts   for,    21- 
23,  26,  28-31,  112-117. 

nature  of,  7-18. 

Partnership  agreement,  112. 

Patents,  105,  370. 

Payee,  411. 

Payment  —  future,  230,  414-423. 

part,  173. 
Petty  cash,  89,  236-238. 
Plant,  99, 
Posting  —  check  for,  146-147,  165. 

defined,  27. 

illustrated,  149-152. 

method  of,  28,  142-143. 
Power,  51,  131,  402. 
Power  plant,  99. 
Premium  —  on  bonds,  373,  377,  380. 

on  stocks,  255. 
Prepayments,  103,   105,  115,  128-130, 

230. 
Present  worth  —  defined,  415. 

formula  for,  420. 

illustrated,  416,  417,  419-422. 

table  for,  424,  425. 
Private  ledger,  199-206. 
Production,  statistics  of,  244. 
Profit  and  loss,  265,  268. 

(see  also  Loss  &  gain). 
Profits  —  confused  with  assets,  263. 

dependent  on  conversion,  80,  81,  225» 

disposition  of,  29,  112, 150,  263,  329- 
3S7' 

effect  of,  on  values,  268. 

increase  of  capital  from,  269. 

undivided,  116,  134,  264. 

(see  also  Loss  &  gain). 
Protest,  notice  of,  94. 
Provision  for  hazard,  see  Hazard. 
Purchase  book,  170,  191. 
Purchase  ledger,  179,  191. 
Purchases,  118, 119,  242,  351. 

Railroad  statistics,  247. 

Rates  —  basis,  for  interest,  418. 

machine,  397,  398. 

supplementary,  397. 
Raw  Material  —  account  for,  53,  64,  96, 

^   391,402. 

mventories  of,  97,  286,  351. 
Real  estate,  99. 
Register,  voucher,  196,  198. 
Rent,  42,  54,  64,  104  {Hs),  115  {bis), 
116, 123,  13s,  402. 


434 


INDEX 


Repairs,  127,  296-300,  301. 
Replacements,  127,  296-300,  301,  306- 

309. 
Reproduction,  see  Duplication,  cost  of. 
Reserve  —  distinguished  from  allowance, 
267,  332. 

for  bad  debts,  108,  333. 

for  depreciation,  107,  267,  332. 

for  hazard,  333. 

for  sinking  fund,  334. 

nature  of,  266,  284,  332. 

secret,  310. 
^^esources,  see  Assets. 
Retirement,  301. 
Returns,  118,  119  (bis),  351. 
Revenue  —  charging  against,  311. 

(see  also  Loss  &  gain). 
Rights,  105. 
Royalty,  53,  64,  370. 
RuUng,  145,  170,  190. 

Sales  —  account  for,  55,  60,  62,  74,  76, 
118,  402. 

of  property,  98,  100,  379. 

related  to  accounts  receivable,  353. 

returned,  119,  351. 

statistics  of,  244,  351. 
Sales  book,  171,  175. 
Secret  reserve,  310. 
Shipments,  91,  182. 
Single  entry,  427. 
Sinking  funds  —  accumulation  of,  333. 

as  annuity,  421. 

property  of,  loi,  333. 

reserve  for,  334. 
Six-column  statement,  223-227. 
Solvency,  314,  340-342,  355-359- 
Space  cost,  135,  402. 
Statement  —  deficiency,  359. 

eight-column,  228. 

insolvency,  355-359- 

of  affairs,  355-358. 

of  assets  and  liabilities,  339-343. 

of  balance  sheet  changes,  348-350. 

operating,  63-66,  74,  80,  351. 

profit  and  loss,  46. 

six-column,  223-227. 

surplus,  289. 

ten-column,  228. 


Statistics,  44-46,  50-52,  60,  78-79,  117- 
119,   120-123,   127,   130-135,   146, 
191,   242-247,  351,  384,  387-389, 
405. 
Stock,  see  Raw  material;  Finished  goods. 
Stock  book,  191. 
Stock  taking,  see  Inventories. 
Stockholders'  ledger,  250. 
Stocks,  see  Capital  stock. 
Stores,  see  Raw  material. 
Subordinate  ledger,  178-182. 
Subscriptions  to  capital  stock,  253,  261. 
Supplementary  ledger,  178-182. 
Supplies,  97,  128,  351. 
Surplus  —  accoimt  for,  116,  266. 

capital,  290,  372. 

donated,  260. 

for  period,  263-265,  349,  351. 

premium,  256. 

special,  266. 

statement  of,  289. 
Suspense  account,  106. 

Tabular  ledger,  193. 

Taxes,  54,  115,  291,  351,  402. 

Temporary  depreciation,  300. 

Ten-column  statement,  228, 

Tickler,  241. 

Trade  marks,  368. 

Trading  —  as  clearing  account,  131, 133, 

Transposition,  161. 

Treasury  stock,  loi,  255,  260. 

Trial  balance,  157-163. 

Undivided  profits,  116,  134,  264. 

Valuation,  365-381. 
(see  also  Balance  sheet,  interpretation 

of;      Capitalization;      Inventories; 

special  accounts). 
Voucher-payable  system,  195-199. 

Wages,  34,  39,  5i,  53,  64,  104,  115,  215, 

216,  219,  351,  391,  402. 
Wasting  assets,  310. 
Work-in-process,  see  Goods-in-process. 
Working  capital,  260. 
Writing  off,  39. 
Writing  up,  see  Appreciation. 


14  DAY  USE 

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7 


